As a business owner, it’s crucial to understand the tax implications when structuring your company as a partnership or electing to be taxed as an S corporation. Failing to navigate these nuances properly can lead to unpleasant surprises and costly mistakes.
One common pitfall I’ve encountered is partnerships that elect to be taxed as an S corp but fail to pay reasonable salaries to the officer-owners. This nullifies a key benefit of the S corp structure – avoiding self-employment taxes on profits. The IRS expects S corp owners to be W-2 wage earners receiving compensation for their services.
Another potential landmine relates to partnership distributions and personal tax liabilities. In a partnership, profits “flow through” to the individual partners who must report and pay taxes on their allocated share, even if the cash remains in the company’s coffers. This can create a liquidity crunch if provisions aren’t made for tax distributions.
To avoid this, many partnership agreements stipulate mandatory tax distributions to the partners, often calculated as a percentage of profits based on assumed individual tax rates. This ensures partners receive enough cash to cover their imputed tax bills from the business’s profits.
The approach varies, but a common method is issuing a tax distribution equal to the highest marginal tax rate (e.g. 37% federal plus state taxes). This simplified calculation avoids having to assess each partner’s specific tax situation.
Alternatively, more precise calculations can be made based on each partner’s actual projected tax liabilities, accounting for their individual circumstances like filing status, other income sources, and deductions.
Regardless of the calculation method, these tax distribution provisions are crucial for partnerships. Neglecting them can lead to partners paying taxes on “phantom income” they never actually received, creating personal cash flow issues.
As your businesses grow and profits increase, getting the tax structure and distribution policies right from the start is vital for both compliance and avoiding unpleasant surprises down the road.
