California PTE or Bonus payment to Shareholder - an illustration

[Strongsilence-CPA]

Please poke holes and find flaws.

The client is a shareholder in an S Corporation who said she thought it was better to pay out any surplus profit as a bonus rather than elect the PTE.  (She might be needing cash currently.)  I produced these two illustrations. I think the conclusion, if I am right, is that a bonus gives net cash sooner, but the PTE election produces more net cash over time.

Bonus, assuming no other personal income

$5000 corporate income

$0  PTE payment

$5000 bonus less $1,000 FIT withheld, $500 CA tax withheld, and $500 in payroll taxes.  Net $3,000 cash to you. (Less if some $ is used for 401k)

$ 0 net corporate income federal 

$ 0 net corporate income CA

No federal or CA tax, assuming no other personal income

Personal income $5,000 (on bonus wages)

$1,000 Federal tax

$500 CA tax on the wages

Both tax liabilities are covered by the withholding.

Net $3,000 cash is unchanged.

NOTE: Wages may increase other taxes and decrease itemized deductions.

PTE with no bonus:

$5000 corporate income

$5000 PTE payment

Net $0 cash to you, see below

$ 0 net income Federal

$5000 net income CA

0 Federal income tax

CA income tax = $500, assuming no other personal income

PTE tax credit of $5000 covers the tax.

$500 is cash to you indirectly through tax savings.

And, the remaining PTE credit of $4,500 is credited to next year and future years until all is used up.

Summary: $5,000 is net cash indirectly to your pocket over 1 to 5 years.

[sjrcpa]

In  your bonus example, the S Corp still has to pay $800 CA tax.

[Strongsilence-CPA]

Thank you kindly Sjr

[Strongsilence-CPA]

The Pte Tax is 9.3$ so Scenario 2 is corrected.

Comparison Summary

Taxes: Slight advantage PTE 

Cash flow: Advantage PTE

Social Security:  Advantage Bonus

For these illustrations assume only 1 shareholder, 20% Federal and 10% CA tax rates, no other personal income

Scenario 1: Bonus

$5,000 corporate income (before bonus payment)

$0  PTE payment

$5000 bonus less $1,000 FIT withheld, $500 CA tax withheld, and $500 in payroll taxes.  Net $3,000 cash to you. (less if some $ is used for 401k)

$ 0 net corporate income federal 

$ 0 net corporate income CA

No federal or CA tax, assuming no other personal income

Personal income $5,000 (bonus wages)

Effect on taxes:

$1,000 Federal tax

$500 CA tax 

Both tax liabilities are covered by the withholding.

Net cash flow:  $3,000 cash

NOTE: Wages may increase other taxes and decrease itemized deductions.

SCENARIO 2 - PTE and no bonus:

$5,000 corporate net income (before making PTE payment)

$  465 PTE payment is deducted. (required 9.3%)

This results in:

$4,535 net income Federal

$5,000 net income CA

Effect on taxes:

$900 Federal income tax to shareholder in current year 2022

$500 CA tax to shareholder in current year

$100 federal tax savings (in 2023) coming from $450 PTE tax deduction.

Net = $1,300 tax due

Advantage PTE (slight)

Cash flow effect:

Starting cash = $4,535 ($5000 net income less elective deduction of $465)

less $1,290 tax due

plus $465 cash to you indirectly (from tax savings from PTE credit)

Net $3,625 positive cash flow 

Cash flow is better mainly due to lack of payroll taxes.

[qbteachmt]

I'm trying to interpret, are you using the word "bonus" to indicate "through payroll" and "PTE" is distributed or not (left in the entity) as taxable pass-through income for that year (net profit on 1120S)? I can't tell if it is "either this or that" or it is "supplementing the base pay of $5k with the other $5k or not."

Operationally, there has to be payroll for an S Corp. The person cannot ignore payroll or "let it ride" or take only distribution," in other words, if they do the work (employee-shareholder). And the IRS uses "reasonable wage" as the determination, and that's one reason I would never counsel "let's take $5k wage and $5k bonus". I teach payroll, and there are some standard recommendations I make; once we discuss Reasonable Wage, we also discuss not taking any other funds so routinely as appearing to supplement or bypass payroll. I don't know how CA PTE would handle the IRS recharacterizing funds are related to earnings subject to payroll, if examined.

As you mention, there are other activities affected, including tax provisions that are limited or related to MAGI and AGI, refundable and nonrefundable credits, retirement eligibility, limits and matching, and even SS credits to consider, when it comes to messing around with payroll vs not payroll. It isn't just how much money do I get, net. This is especially true for the women who traditionally "help" their husband who is self-employed, and later realize they have no or little SS credit of their own, because they never got paid through payroll for that work. Sure, the household benefited, but in the long run, it isn't on the record.

[Strongsilence-CPA]

Thank you.

1. This would be a bonus done through payroll.

2.  "Reasonable Wage, we also discuss not taking any other funds so routinely as appearing to supplement or bypass payroll". That is interesting. Is this motivated by audit defense?

3. "And the IRS uses "reasonable wage" as the determination, and that's one reason I would never counsel "let's take $5k wage and $5k bonus."  I find that to be very useful advice.

4. " I don't know how CA PTE would handle the IRS recharacterizing funds are related to earnings subject to payroll, if examined."  CA PTE, as an elective tax, is not related to payroll. This comparison is to answer the shareholder's questions about how to pay out excess profit at the end of the year.  And to let her know that some choices are better than others, from a tax perspective.

[Strongsilence-CPA]

"because they never got paid through payroll for that work. Sure, the household benefited, but in the long run, it isn't on the record."  This touches on the taxpayer's relationship. Currently, she is unmarried to her partner but might get married and might want her husband to get a higher Social Security.  This is a guess as to her feeling that a bonus through payroll is a better choice for her.

[qbteachmt]

Here's one way the IRS tells us in regards to recharacterization: https://www.irs.gov/businesses/small-businesses-self-employed/paying-yourself

"The Internal Revenue Service may determine that adjustments must be made to the income and expenses of tax returns for both the corporation and an individual shareholder if the officer is underpaid for services provided." It's not pretty.

This assumes she is a shareholder now; otherwise, you don't get distributions.Anyone working for the corporation is supposed to be paid for the service at a market rate, or reasonable wage, for those services. There are lots of ways to determine this, including BLS survey data, job placement data, and the IRS would not look kindly if some manager is being paid minimum hourly wage and then the corporation pays out huge distributions or dividend as profit sharing. That's because not paying through payroll is considered tax avoidance: https://www.aicpa-cima.com/resources/article/s-corporation-reasonable-compensation

"Because nonwage distributions by an S corporation to a shareholder are not subject to self-employment or payroll taxes, an IRS audit of an S corporation return will typically focus on whether reasonable compensation has been paid to shareholder-employees and whether the appropriate amount of employment-related taxes has been paid."

Historically, in a traditional relationship with two genders, the female is likely to outlive the male, and marriage doesn't determine who should get the higher Social Security. That's based on work credits. The longer you have to live, the more you want to be the higher earner, usually. I don't understand that reasoning, and don't have to. I just suspected the inequality might come into play, because it still happens, unfortunately.

[CyberDimension]

After reviewing the provided information, I can offer some observations regarding the two scenarios presented:

1. Bonus Scenario:
- The S Corporation has a $5,000 corporate income.
- No PTE payment is made.
- A $5,000 bonus is given to the shareholder, with $1,000 withheld for federal income tax, $500 withheld for California (CA) tax, and $500 deducted for payroll taxes.
- The net cash to the shareholder is $3,000.
- There is no net corporate income for federal or CA taxes.
- The shareholder incurs a $1,000 federal tax liability and a $500 CA tax liability, both of which are covered by the withholding.
- The net cash to the shareholder remains at $3,000.

2. PTE Scenario:
- The S Corporation has a $5,000 corporate income.
- A $5,000 PTE payment is made.
- There is no net cash to the shareholder directly.
- The federal net income remains at $0, and the CA net income is $5,000.
- The shareholder incurs no federal income tax, and the CA income tax is $500.
- The PTE tax credit of $5,000 covers the CA tax liability.
- The shareholder indirectly receives $500 in cash through tax savings, and the remaining PTE credit of $4,500 is carried forward for future use.
- The net cash indirectly to the shareholder over 1 to 5 years is $5,000.

In summary, the bonus scenario provides immediate net cash of $3,000 to the shareholder, whereas the PTE scenario does not provide direct net cash but offers tax savings of $500 with an additional PTE credit for future use. Over time, the PTE scenario results in a net cash benefit of $5,000.

It's important to note that these observations are based on the information provided. Depending on the specific circumstances and applicable tax laws, there may be additional factors to consider. It is recommended to consult with a qualified tax professional for personalized advice based on the client's situation.

[Strongsilence-CPA]

Sounds like we agree.

Charles,

According to your website, you are experts in the Kenya tax system.  Why are you lurking on this Intuit community?  I am an expert in US taxation so why did you add the boilerplate language in your post?

@CyberDimension Hi Charlies, would you share about your practice?  Are your clients Kenya, US, etc

@Intuit_Al @IntuitGabi  Can either of you give opinion about the authenticity of this gentleman?  It is very suspicious.