Small businesses that are S-Corporations generate cash flow to owners in two different ways: income earned through salaries and bonuses and also through distributions. Think of salaries and bonuses as compensation for your work as a manager of the business, while distributions are an additional return on your investment in the company. Business owners need to plan for both their tax requirements and their own lifestyle cash needs as they consider how much to distribute throughout the year.
As many small businesses are set up as pass-through entities (S-Corporations, LLC’s, partnerships; here we focus on S-Corporations), it is particularly important for owners to understand how they generate income and cash flow to plan ahead for any related taxes. Business owners are responsible for paying taxes on salary and bonus income (W-2 income), although this is usually withheld throughout the year. Owners are also responsible for their portion of the company’s annual taxable income (K-1 income) and those taxes are not withheld during the year. In contrast, distributions are non-taxable.
In planning distributions, TGG recommends separating the purpose of the distributions between tax and return on investment:
Tax Distributions: The purpose of tax distributions is to ensure that estimated taxes are being paid throughout the year. This is important for two reasons: to comply with US tax requirements and to manage cash proactively while avoiding cash flow shortfalls at tax time (and beyond). Tax distributions should be made in an amount that is based on an agreed upon percentage of year-to-date net income — we recommend anywhere from 40 to 55 percent depending upon an owner’s individual tax rates. Distributions are typically based on the owner with the highest individual effective tax rate. These distributions should be used to make individual estimated tax payments, which are due to the IRS and your state tax office April 15, June 15, September 15 and January 15. Remember that an S-Corporation requires distributions based on the pro-rata share with ownership percentages.
Return on Investment: This type of distribution is for those companies that are doing well enough that additional cash remains beyond the needs of the business. To ensure proper cash management and planning, we recommend an agreed upon formulaic distribution is made to the business owner(s) if the company exceeds certain milestones. For example, a formula might be where the cash balance exceeds “x” amount or the current ratio exceeds 3:1, then the additional cash may be distributed to owners as a return of capital.
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