Appendix B: Tax Calculations for an Example Pass-through Taxpayer

Tax Calculations

S Corporation, Two Shareholders, Distributes B to Shareholders

Taxpayers B1 and B2 formed an S corporation, using $100,000 of money they saved to start a business. B1 contributed 75 percent of the money, $75,000, and owns 75 of the 100 shares of stock. Taxpayer B2 contributed $25,000, and owns 25 of the 100 shares of stock. Both work full-time for the S corporation. They rent a storefront and sell widgets.

The S corporation must file form 1120S, the U.S. Income Tax Return for an S Corporation. The table shows the items reported for this simple example business on form 1120S.

Table B-1

Gross receipts $225,000
Cost of goods sold $100,000
Gross profit $125,000
Total income $125,000
Deductions
Compensation of officer B1 $40,000
Compensation of officer B2 $40,000
Rents $15, 000
Taxes (payroll for officers) $6,120
Advertising $2,0 00
Total deductions $103,120
Ordinary business income $21,880

The $40,000 of compensation paid to the two officer/owners of the S corporation is subject to payroll taxes. The S corporation itself pays the employer share, totaling $6,120, and each of the two officers pays the employee share, $3,060 each, which the corporation withholds from their compensation. The S corporation itself does not pay any tax on its profits or ordinary business income, but rather the income is allocated to the two shareholders for tax purposes. (As noted later, it doesn’t matter for tax purposes whether the corporation actually distributes or retains these profits to its shareholders). The business income is reported on Schedule K, a supporting schedule to Form 1120S. The S corporation reports $21,880 of ordinary business income on Schedule K. The S corporation provides each shareholder with a schedule K-1, which reports their pro-rata share of the income. Taxpayer B1 receives a K-1 showing $16,410 of ordinary business income. Taxpayer B2 receives a K-1 showing $5,470 of ordinary business income. Since taxpayer B1 owns 75 percent of the shares of the S corporation, he is allocated 75 percent of the income and distributions, while taxpayer B2, who owns 25 percent of the shares, is allocated 25 percent.

Taxpayers B1 and B2 are both active in running the business, so they report the income on line 28J of Schedule E, a supporting schedule to form 1040. This same amount is then transferred to line 17 of form 1040 and included in taxable income. They also report the wages they received as officers of the S corporation on form 1040. The second table summarizes the total income and payroll taxes paid as a result of the S corporation business activity.

Table B-2

S corporation
Payroll taxes on for officers’ compensation $6,120
Taxpayer B1
Payroll taxes withheld on $40,000 compensation $3,060
Federal income tax on $16,410 business income (25% bracket) $4,103
Federal income tax on $40,000 wages received as officer (25% bracket) $10,000
Minnesota income tax on $16,410 business income (7.05% bracket) $1,157
State income tax on $40,000 wages received as officer (7.05% bracket) $2,820
Total paid by B1 $21,139
Taxpayer B2
Payroll taxes withheld on $40,000 compensation $3,060
Federal income tax on $5,470 business income (25% bracket) $1,368
Federal income tax on $40,000 wages received as officer (25% bracket) $10,000
Minnesota income tax on $5,470 business income (7.05% bracket) $386
State income tax on $40,000 wages received as officer (7.05% bracket) $2,820
Total paid by B2 $17,633

One advantage of operating a business as an S corporation is that payroll taxes only apply to the compensation paid to the officers, and not to the business income that flows through to Schedule E.31 This contrasts with the treatment of a sole proprietorship or a partnership, in which the net profit of the business is subject to payroll taxes. The IRS requires S corporations to maintain a “reasonable” level of compensation of officers and may reallocate income from the ordinary business income to compensation of officers, thus subjecting it to payroll taxes, if they determine that the S corporation is attempting to avoid payroll taxes by setting the officers’ compensation too low and the ordinary business income too high.

S corporations are not required to actually distribute the income for the year to the shareholders; many choose to retain all or part of the income as working capital for the business. But the shareholders’ pro-rata shares of income still must be reported to them on Schedule K-1, and they must include it on Schedule E of their federal tax return and pay income tax on the income, even though they never actually received it. This is sometimes referred to as “phantom income.” Taxpayers B1 and B2 adjust their basis in the S corporation upward by the amount not distributed. This will result in B1 and B2 realizing a smaller gain (and paying less tax) in the event they sell their shares in the S corporation. The next table shows the basis adjustment calculation for B1 and B2.

Table B-3

Taxpayer B1
Original basis (capital contributed to start business) $75,000
Income not distributed $16,410
Adjusted basis $91,410
Taxpayer B2
Original basis (capital contributed to start business) $25,000
Income not distributed $5,470
Adjusted basis $30,470

If taxpayer B2 sold his share of the business for $50,000, his gain would be $19,530, since his original basis of $25,000 was adjusted upward by the amount of income not distributed.

In practice, many S corporations typically distribute at least enough income to shareholders to cover the federal and state tax due on that income. To accomplish that, the S corporation would distribute $7,013 of income and retain $20,127 for working capital moving into the next year. Taxpayer B1 would get 75 percent of the amount distributed, or $5,259, enough to pay the $4,103 in federal income tax and $1,157 in state income tax on his full $16,410 share of the business income. Taxpayer B2 would receive 25 percent of the amount distributed, or $1,753, which would cover the $1,368 in federal income tax and the $386 in state income tax he has to pay on his full $5,470 share of the business income. In that situation, taxpayer B1 would adjust his basis in the business upward by $11,151 (the $16,410 of business income, minus the $5,259 distribution). Taxpayer B2 would adjust his basis upward by $3,717 (the $5,470 of business income, minus the $1,753 distribution).


The content of this and any related posts has been copied or adopted from the Minnesota House of Representatives Research Department’s Information Brief, Taxation and Small Businesses in Minnesota, written by legislative analysts Nina Manzi and Joel Michael.

This post is also part of a series of posts on the tax implications of different business entity types.


31 Note that doing this will adversely affect the shareholder/employee’s Social Security benefit entitlements, since the shareholder/employee will have a lower earnings history. For higher income individuals, this is typically a minor consideration since their return on Social Security taxes paid is negative—i.e., the present value of Social Security taxes paid is less then the present value of the benefit entitlements earned. That may not be the case for individuals with very low earnings histories. Social Security death and disability benefits further complicate the calculations.