This month, our School of Tax Strategy is focused on S corporations. An S corporation can be a terrific entity for an operating business. It is a "flow-through" entity, so there is only a single tax on the income - at the shareholder level. And there can be significant payroll tax savings to using an S corporation. One of the questions I received this month about S corporations is the following:
"If my S corporation owes me money, should I take cash out as a loan repayment first and wait to take a salary & distributions until it is fully repaid?"
This question comes up in many start up companies. When you are first starting out, it is likely that you had to put in some money to pay expenses until the business became profitable. When the business starts to be profitable, you have money that you would like to take out.
At first glance, the answer to this question seems to be "Yes." After all, a loan repayment is not subject to social security taxes like salary. If the money that's available came solely from the profits of the business, you are probably safe taking it out as a loan repayment.
However, there could be an adverse tax consequence to the loan repayment. Let's say, for example, that you had losses in your first two years of operation. These losses were funded by your loans to the company. Let's say that in year 3, you obtain a bank loan. You are still operating at a loss or break even, but the bank has decided to loan money to the company and you want to take it out to pay some personal bills.
Your first inclination may be to pay back your loan to the company. The only problem is that if you do this, you will likely pay tax on the loan repayment. Why? Because in an S corporation you do not receive tax basis for loans to the company from outside parties. So, you received basis for your loan to the company. Then, you took losses on your tax return the first two years and reduced your basis in your company. At least some of that basis came from your loans to the company. Now, your loan basis is less than the face amount of your loans. As a result, when you pay back these loans, you could have capital gains from the repayment.
If this seems a little complicated and confusing, IT IS! The answer is to talk to your CPA prior to taking out the money. Have them run through the calculation to determine the best way to classify the money you take out for tax purposes. Otherwise, you could have a surprise tax bill come April 15th on the capital gains from the loan repayment.
So be sure to stay in contact with your CPA throughout the year and be sure you learn the rules for taking money out of your S corporation.
Warmest regards,
Tom