Q: You mentioned that an S Corp’s reported net profit is really pre-tax profit. How do I determine or fine what the actual tax liability is on that income so I can deduct the taxes when calculating cash flow available to service debt? It’s confusing because if you go to the owner’s personal income tax return, his or her total tax liability may include other sources of income besides the S Corp income such as wages, capital gains, interest income etc. How do you determine just the portion of tax liability due on S Corp income?
A: It is very confusing. One practical way is to estimate the owner's effective income tax rate by dividing his or her Total Tax from Form 1040 by Adjusted Gross Income reported on Form 1040. Then apply this rate to the taxable revenue reported on the owner's Schedule K-1 (Form 1120S) from the Subchapter S corporation to estimate the tax liability for the company's taxable income.
However, it is more useful and practical to adjust the full amount of distributions since they are used for a combination of income tax payments on taxable business income and for owner compensation. Both are operating expenses. Therefore, the full amount of distributions should properly be deducted from Subchapter S corporation reported net profit to arrive at profit – not cash flow – available to service company debt.
In addition, we recommend deducting loans to the owner from the company, along with distributions, since loans to owners are frequently advance distributions. They are subsequently converted to distributions by a simple set of accounting entries. Loans are cash out the door, which reduces cash available to service company debt.
Q: Would this salary income be in the form of a W2?
A: Salaries are indeed reported on the W-2.
Course overview: Business Income Tax Returns