Most owner/operators of s corporations are required to officially run payroll. Here is a simple guide to what you need to know.
Warning: This article is only meant as a general guide. There are many situations in where the information presented here may not be applicable to your tax situation. We strongly recommend that you consult with a CPA or an EA concerning your s corp and your income taxes. Incorrectly operating or filing your s corporation taxes can lead to large penalties and other unfavorable actions again you and/or your s corporation.
S corporations might create a tax savings
Small business owners form s corporations because they sometimes create large savings, especially with self employment taxes. S corporation shareholders might also pay less in “additional Medicare” taxes.
Also, they seem to enjoy a lower historic rate of examinations (audits), and the rules might benefit a taxpayer when facing a multi-year disallowance in an audit.
S corporations are not always the best bet for all small business, however, as there are payroll and tax matters to deal with that do not exist for the more simple types of taxation rules.
Penalties for non compliance, for example, are much more intense and stringent than they are for sole proprietors.
As a general rule of thumb, if your small business is not making more than $60,000 per year or so in net profit, after expenses, then an s corporation might not yet be appropriate. This is because the compliance expenses are generally more or nearly as much as the tax savings.
We do offer a consultation to see if s corporations are correct for your business. Check out our small business taxes page here.
Active s corporation owners are required to run payroll
One such compliance rule for s corporations is the “reasonable salary” requirement.
The IRS says that s corp owner/operators who provide more than minimal services to their s corporation must pay themselves as employees of the s corporation. This ensures that both the employee and the employer pays their appropriate share of social security and medicare taxes.
The advantage of this structure is that owners can generally take the remaining profits as dividends to shareholders of the s corporation – which are not subject to these social taxes.
This can create a large tax advantage over sole proprietors in some cases because sole props pay both the employer and employee social taxes on 100% of their net profits.
One problem that s corporation owner/employees face is that “reasonable salary” has not clearly been defined as far as an amount is concerned.
Historically, there have been many cases in where s corporation owners pay themselves a very small salary and take very large dividends. Under audit – these “unreasonable” payroll amounts do not hold up – and the IRS can go back many years in a dis-allowance. This can result in a very large tax bill with pretty large penalties.
There are many factors as to what might be considered reasonable and there are so many variables that we can’t effectively discuss them all here. Please talk it over with a professional.
Another thing we run into from time to time is an s corporation that has been operating with profits but no payroll has been run. If you are in this situation, then you are probably “doing it wrong”. This will almost certainly catch up to you and it will not be pleasant. We recommend that you contact a tax practitioner who understands s corps right away.
Note, however, that there are some exceptions to where payroll does not need to be run.
Running payroll is somewhat complex
Another roadblock to s corporation compliance is that the payroll must be ran legitimately. This requires official paycheck calculation and payroll bookkeeping. It requires periodic electronic tax deposits for federal payroll and withholding taxes, state withholding taxes, state unemployment taxes, and federal unemployment taxes. Each of these payments also has an associated tax return that is due periodically, and there are also annual forms to file such as the W2, W3, and state equivalents.
It is actually not very expensive to hire a payroll practitioner to do all of this for you. Generally, as previously mentioned, if your small business is showing a net profit of more than $40,000 per year, the tax savings and other advantages of organizing an s corp will offset the additional accounting costs to handle all of this. A business making $100,000 in net profit each year will likely see a very large tax savings – even with the added payroll processing, depositing, and filing costs. Again, every situation is different. Even with a nice-sized net profit, there may be other reasons why an s corp may not be appropriate for your situation.
Payroll creates a tax planning advantage to the owner
Another advantage of operating as an s corp and running payroll (besides paying less taxes) is that you can stabilize your income and tax situation somewhat. Paying quarterly estimated taxes on your business is somewhat “clunky”. It often means that you underpay or overpay, and you have to come up with large lump sums of tax payments each quarter or at tax time.
When you run payroll, you can withhold the forecast income tax liabilities form each paycheck – which makes paying taxes a little more like having a job than owning a small business. Many small business owners really like this advantage from s corporations and running payroll.