Dear Tax Talk,

My husband and I own an electrical business. It is set up as an S corporation. I am having trouble understanding the income tax as it pertains to us. I also work outside the home. I understand that all our income is my income, plus the income of the company.

My husband takes a small salary and puts the earnings back into the business. When it comes time to pay taxes on the earnings (which will be large this year) we have always written the tax payment on the company check. Is this correct? I feel like we should be writing it out of our own account, since it’s all our income even though we aren’t bringing it home. I’m just confused.

Also, my husband seems to think he has to buy equipment that he really doesn’t need to help offset the taxable income. Can we buy anything — like a boat or a lake house, or does it have to pertain to the business?

— Kim

Dear Kim,

It sounds like you have it pretty clear what you’re doing except for a few minor points.  The income of an S corporation is taxed to the shareholders. The shareholders pay tax on the income of the S corporation by including the income on their individual income tax return.

Principally, Schedule E page 2 is used for this purpose. However, certain other income from an S corporation is reported on other schedules. For example, interest flowing through from the S corporation would be reported on the shareholder’s Schedule B.

By including the income on his tax return, the shareholder is entitled to receive earnings of the S corporation in cash, equivalent to the net amounts reported. The distribution does not result in any additional income tax. 

The shareholder does not have to receive the cash equivalent during the current year. The amount can be accumulated and carried forward for distribution in subsequent years. The S corporation maintains an accumulated adjustments account that should help a shareholder determine the amount of earnings he or she is entitled to receive in cash without further tax consequence.

The accumulated adjustments account is reconciled on page 4 of Form 1120S.  Distributions to a shareholder can either be in direct payments to the shareholder or indirect payments for items that benefit the shareholder. The payment of your individual income taxes with a company check would be an example of an indirect distribution. 

You’re right that the payment of the tax is a personal item of you and your husband.  However, it is not uncommon for an S corporation to actually write the check and treat it as a distribution of earnings to the shareholder. The outcome is the same as if the S corporation had provided you with the funds and you issued the check individually. 

Spending money for items that the S corporation does not need in its business is not a sound tax saving strategy. The purchases only save tax at your marginal rate; the remainder comes out of your pocket.

It does make sense for your husband to stock up on work supplies, small tools and equipment that he can write off at the end of the tax year that he will use in the following year. We refer to this as accelerating deductions.

Unfortunately, you cannot write off the cost of personal use assets such as the boat or lake house. These items are not business related.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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