How to Make Estimated Quarterly Payments for S Corporations
New S corporation owners can often get confused about both why and how one should pay the taxes associated with the income an S corporation generates. So let me explain how this works.
Calculating Taxes on S Corporation Profits
Let me first review how S corporations affect the taxes their shareholders owe. (If you already understand this, go ahead and skip to the next section.)
So here's the deal with an S corporation: It allocates its profits or its losses to shareholders based on their proportionate shares. For example, if four shareholders equally own an S corporation, that means each shareholder gets allocated one-quarter, or 25%, of the S corporation's profit.
In the case where the S corporation makes $100,000 in profit, therefore, each shareholder gets allocated $25,000 of profit. And the shareholder-not the S corporation-needs to pay the federal and state income taxes on the profit.
One final point about this allocation of profit: It doesn't matter whether the S corporation distributes, or pays out, the profit share or not.
The shareholder with the 25% interest in the $100,000 of profit will owe taxes on his or her $25,000 profit share even if the S corporation retains the profit.
Deducting S Corporation Losses
A related point to bring up: If you are a shareholder in an S corporation and the S corporation loses money, you shouldn't owe any income taxes due to the S corporation's activities. Quite the opposite, in fact.
If the S corporation suffered a $100,000 loss, for example, each shareholder gets allocated $25,000 of loss. And in this case, the shareholder puts this $25,000 loss on his or her tax return and very possibly gets a deduction that reduces the taxable income the shareholder reports and pays tax on for the year.
There are some limits to claiming these losses, but I'm going to skip a more detailed discussion of those losses here.
Paying Taxes on the Profit Share
When the shareholder reports the S corporation profit share on his or her tax return, the shareholder will owe federal and state income taxes on the profit share.
Just for the record, a shareholder can postpone dealing with this tax liability until tax return time. In this case, though, two bad things happen.
First, the shareholder finds him- or herself dealing with a last-minute tax payment. On a $25,000 profit share, for example, a shareholder with other income such as from a job might owe $8,000 or so in income taxes. That's a lot of money for most people to come up with by April 15.
Second, if the taxpayer delays paying taxes on the profit share until April 15, the IRS and the equivalent state agency charges the taxpayer interest. Why? Because the federal and state government don't want to wait until April 15 for their money. Rather, they want the shareholder to pay the taxes owed in even, quarterly chunks in the year in which the profit is earned.
Specifically, the government wants the shareholder to pay a quarter on April 15 and then another quarter on June 15, September 15, and on January 15 in the next year.
In the case where a shareholder owed $8,000 in taxes on his profit share, he or she should pay $2,000 quarterly deposits on April 15, June 15, September 15 and on January 15.
Note: Logically, it doesn't make any sense for the second quarter's payment to occur even before the second quarter ends on June 30. Accordingly, don't try to figure this out.
To make quarterly deposits with the Internal Revenue Service, a person uses a 1040-ES form, which is available from the Internal Revenue Service website. The form is very easy to prepare. All you do is write in your name and social security number (and your spouse's if married) and then the payment amount.
Note: States use a similar "quarterly estimated deposit" system with their own forms. But follow the form instructions carefully for your state. Some states have created more complicated formulas and rules. California, for example, makes you accelerate your quarterly payments so that seventy of your annual tax is paid June 15.
Tricks for Simplifying S Corporation Shareholder Quarterly Deposits
Let me share a handful of quick comments about simplifying quarterly deposits.
1. Some S corporation shareholders don't worry about the quarterly payments. And that works okay as long as you don't get surprised or blindsided by the extra tax you'll owe on the profit share you get allocated. Note that the interest charges the IRS and that the state levies aren't for the typical S corporation shareholder all that bad. Your credit card for sure and probably also your local bank charge you higher interest rates.
2. You can over withhold on your wages and this over withholding can make up for underpaying your quarterly payments. For example, if you're supposed to pay $2,000 a quarter (or $8,000 for the year), you could also just have your employer (perhaps the S corporation?) withhold an extra $666.66 each month from your wages. In this case, sure, you do sort of "underpay" the quarterly deposits. But because you "overpay" through payroll withholding, no penalty or interest charges get levied.
3. Good S corporation manners require you to alert shareholders about anticipated profit shares so shareholders can plan. Good manners also dictate that in almost all cases you pay distributions at least adequate for estimated tax payments. You would not, for example, want to lay a $25,000 profit share on some shareholder and then expect them to shoulder the possibly $8,000 tax liability on their own. Or, at least, you would not do this if you want to keep your shareholders happy.
4. Because amounts withheld from employee wages are never "late," some small S corporations with working shareholders do an annual payroll for shareholder-employees and then withhold the perfect amount from that giant, just-before-year-end paycheck. For example, say someone owes in total $20,000 in taxes on $40,000 of wages earned and a $60,000 profit share. A person could pay the $40,000 of wages in December as a $40,000 chunk or in a couple of $20,000 chunks in November and December. When these wages are paid, the $20,000 in income taxes could just be withheld then. This approach lets the shareholder-employee delay a tax payment without penalty or interest (one benefit). And this approach also lets the shareholder-employee withhold nearly the perfect amount in taxes since by the end of the year the taxable income should be easily accurately estimate (a second benefit).
Note: When a shareholder-employee does do a year-end payroll, the shareholder typically has the S corporation make distributions through the early months of the year so that the shareholder receives the cash flow necessary to buy groceries and pay the rent. For example, using the example numbers of $60,000 in profit share and $40,000 in wages, what an S corporation and shareholder might do is pay $6,000 a month distributions out of profit for the first ten months of the year, January through October. This means that through the first ten months of the year, the S corporation distrbutes $60,000, which is all of the profit share. Then, in both November and December, the S corporation would pay the shareholder-employee $20,000 a month in payroll but withhold $10,000 in income taxes for both months. This would mean that the "net" wages received would be about $10,000 a month for these two months. And that at year-end, that the shareholder employee had paid all of income taxes owned on the $60,000 profit share and the $40,000 of wages.
S Corporation Quarterly Deposit Traps
In a handful of unusual situations, if an S corporation used to be a C corporation, the S corporation itself may owe income taxes on a portion of its profits if it's been careless.
For example, an S corporation may owe something called built-in gain tax on a portion of the S corporation profit that really stems from the years when the corporation operated as a C corporation. Or an S corporation can owe income taxes for something called LIFO recapture or on excessive passive income. (See here for more details about these taxes.)
If your S corporation used to be a C corporation, you should confer with your tax advisor for help calculating the amounts of these taxes. And once you have that estimated tax liability, know that the S corporation (not its shareholders!) should make quarterly estimated tax deposits for this liability. To make such a deposit, the S corporation would use its EFTPS account. EFTPS is the same system that businesses use to make payroll tax deposits, so if you're an S corporation you should already have an EFTPS account set up.
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