OTLA Trial Lawyer Winter 2021

34 Trial Lawyer • Winter 2021 to the owners for taxation on their indi- vidual tax returns. The owners then pay income tax on their allocation of the net taxable income with their individual tax returns. However, in this model, owners are taxed on retained earnings (as op- posed to C-corps), meaning if there is cash in the firm account at the end of taxable year, the owner(s) are taxed on that amount whether it is distributed or not. Therefore, the economics of this model often dictate that the firms carry no retained earnings or “zero-out” at the end of the year. Within an S-corp, there is pure pass through taxation and a modified pass through taxation election. The main difference between the two is the permis- sible classification of the owner as an employee and the flexibility in the distri- butions. In pure pass through, owners may not be classified as employees of their own firm. Instead of wages, these owners get their share of what is left over after all other nonowner compensation and expenses are paid. Periodic draws may be taken against their anticipated year-end distribution but all owner draws are subject to the self employment taxes. The effect of the “pass through” depends on the ownership structure between the owners. Under this scenario, a business has great f lexibi l i ty in al locat ing distributions. A firm can modify this under an S- election, which allows owners to be employees of the company. The owner is paid a reasonable wage that is classified as a firm expense that is also subject to employer-side and employee-side em- ployment taxes. After all business ex- penses are deducted (including the own- ers’ wages), any profits of the firm can be distributed as a dividend that is not subject to the employment taxes. In this scenario, as opposed to pure pass through, all dividends must be made in strict proportion to ownership. Therefore, if your firm has three partners, each with differing ownership percentages, all dis- tributions must match each partner’s pro rata ownership. For instance, if the an- nual distribution is $100k and Partner A has 25%, Partner B has 30% and Partner C has 45%, then each partner would be limited to exactly $25k for Partner A, $30k for Partner B and $45k for Partner C. Under the pure pass through, the partners could have more flexibility in how (and for how much) these distribu- tions were allocated. Determining the proper tax classifica- tion is not a legal question. You or potential business clients should be directed to an accountant. Within an S-corp, there is pure pass through taxation and a modified pass through taxation election. Business Structure Continued from p 33