Profits that a business has made but hasn’t given to shareholders as dividends are known as retained earnings. Retained earnings in a S corporation (S corp) are subject to particular tax laws that are different from those that are applied to regular businesses.
S corporations are pass-through businesses, which means that the business’s gains and losses are transferred to the shareholders’ individual income tax returns. S corporations do not personally pay income tax on their earnings. Instead, regardless of whether the company’s profits are dispersed as dividends or kept in-house, shareholders must pay tax on their portion of those profits.
Whether or not profits are deemed “passive” affects how retained earnings are taxed in a S company. Unlike active income from the company’s main business operations, passive income comes from sources like interest, dividends, and rental income.
The 3.8% Net Investment Income Tax (NIIT) is applied to profits from passive income that are retained by a S corporation. The lesser of the shareholder’s modified adjusted gross income beyond a particular threshold or the company’s net investment income is subject to this tax.
On the other hand, the NIIT does not apply to retained earnings that come from ongoing business operations. On their portion of the company’s profits, shareholders will be taxed at their personal income tax rate.
The short answer to whether holding a S corp qualifies as self-employment is no. Because they get a salary from the company and are subject to FICA taxes as workers on that compensation, shareholders of S corporations are not regarded as being self-employed. They still have to pay self-employment tax on the portion of the business’s profits that gets passed along to their personal income tax returns.
Finally, the specific facts of each business will determine whether LLCs or S companies pay more taxes. While S corporations may be able to save money on payroll taxes by dividing their profits between wages and distributions to avoid paying payroll taxes on the distribution component, LLCs are typically subject to self-employment tax on all of their income.
In order for shareholders to appropriately plan for their tax liabilities, it is critical that they understand how retained earnings are taxed in a S corp. To ensure compliance with the intricate tax regulations that apply to S corporations, it is crucial to speak with a tax expert.