Understanding Payroll for S Corporations

An S corporation is a type of business that enjoys the benefits of incorporation without being subject to double taxation. Unlike regular corporations, where both the corporation and shareholders are taxed on their earnings, S corporations have a unique tax structure. Shareholders of S corporations pay income tax on their earnings individually, while the corporation itself is not subject to income tax. Additionally, shareholder distributions in the form of dividends are not subject to Medicare and Social Security taxes, known as FICA taxes.

However, S corporation members cannot simply take all of their income as distributions. Shareholders who also work for the business are considered employees and are required to receive a salary. Consequently, even if there is only one shareholder/employee, most S corporations need a reliable payroll system.

So, how do S corporations manage their payroll? Like other businesses with employees, S corporations calculate income tax, FICA taxes, and unemployment taxes based on the wages earned during each pay period. However, S corporations have more flexibility when it comes to payroll, particularly if there is only one employee/shareholder. In such cases, individuals may choose to pay themselves at varying frequencies or divide their income into smaller regular payments and a larger year-end bonus.

Paying Yourself as an S Corporation Owner

S corporation owners who are both shareholders and employees typically pay themselves through a combination of distributions and a salary. The salary is necessary if the individual provides significant services to the business. Here is a breakdown of how paying a salary as an S corporation owner is done:

1. Set a reasonable salary: S corporation shareholder-employees must receive a salary comparable to what similar businesses would pay employees for similar job duties.

2. Calculate payroll and taxes: Once the salary is determined, S corporation owners divide the annual salary by the number of pay periods (monthly, quarterly, etc.). This figure is used to calculate income tax, FICA taxes, and unemployment taxes.

3. File federal quarterly payroll taxes: Shareholder-employees typically use IRS Form 941, Employer's Quarterly Federal Tax Return, to report income and FICA taxes withheld from their salary, as well as the portion of payroll taxes paid by the S corporation. They may also need to file Form 1040-ES, Estimated Tax for Individuals, to report estimated taxes on any additional income not subject to withholding.

4. Record payroll transactions: S corporations categorize payroll transactions as wage expenses (salary and income tax), payroll taxes, or shareholder distributions for recordkeeping and reporting purposes.

5. File state payroll taxes: S corporation owners who need to pay state income tax and unemployment tax can usually file these payments quarterly, similar to federal taxes. Some states use tax return worksheets similar to IRS Form 941.

6. Prepare annual tax returns: At the end of the year, S corporations must prepare several tax documents, including Form W-2 (Wage and Tax Statement) for employees, Form W-3 (Transmittal of Wage and Tax Statements) summarizing the W-2 information, Form 1120S (U.S.
Income Tax Return for an S Corporation) reporting the business's income, and Schedule K-1 (Form 1120-S) reporting individual shareholders' income, deductions, and tax credits.

Determining a Reasonable Salary for S Corporation Owners

A reasonable salary for S corporation owners is one that comparable businesses would pay employees for similar job duties. The IRS considers several factors to determine reasonable compensation, including training and experience, time and effort dedicated to the business, dividend history, payments to non-shareholder employees, timing and manner of bonuses, compensation agreements, and the use of a formula for determining compensation. If the IRS determines that an S corporation owner did not receive a reasonable salary, they may reclassify distributions as salary, requiring the owner to

Tandy Consulting can help you with a comprehensive Reasonable Compensation Report.

What is the 60/40 Rule?

The 60/40 rule is a guideline that S corporation owners can use to determine the allocation of their income between salary and distributions. According to this rule, 60% of the business income is designated as salary, while 40% is paid out as shareholder distributions.

The rationale behind the 60/40 rule is to ensure that S corporation owners pay themselves a reasonable salary for the services they provide to the business. By designating a significant portion of the income as salary, owners can ensure compliance with tax regulations and reduce the risk of being audited or penalized by the IRS.

It is important to note that the 60/40 rule is not an officially approved IRS regulation or requirement. It is simply a commonly used guideline that provides a framework for determining a reasonable allocation between salary and distributions.

Ultimately, the determination of a reasonable salary should be based on factors such as industry standards, job responsibilities, qualifications, and other relevant considerations. S corporation owners should consult with tax professionals or accountants to ensure they comply with the IRS regulations regarding reasonable compensation.

Can I put my child or children on payroll?

Yes, it is possible to put your children on payroll if they perform legitimate work for your business and receive a reasonable salary for their services. However, it is essential to ensure that the arrangement is structured appropriately and follows legal and tax regulations.

If done correctly your child will not be required to file a tax return and will be eligible for IRA contributions.

When considering putting your children on payroll, here are some key factors to consider:

1. Legitimate work: Your children must perform actual work for your business that is appropriate for their age and capabilities. This work should be necessary and contribute to the operations or activities of the business.

2. Reasonable salary: The salary you pay your children should be comparable to what other employees would receive for similar work in your industry and geographic location. It should align with the fair market value for the services they provide. Paying unreasonably high salaries to children for work they are not qualified or capable of performing may raise red flags with tax authorities.

3. Recordkeeping: It is crucial to maintain accurate records of the work performed by your children, including the nature of the tasks, hours worked, and compensation paid. This documentation will be essential for substantiating the legitimacy of the arrangement.

4. Compliance with labor laws: Ensure that the employment of your children complies with applicable labor laws, including minimum working age requirements, restrictions on working hours, and any necessary permits or certificates.

5. Tax considerations: By putting your children on payroll, they become employees and will be subject to income tax withholding, Social Security, and Medicare taxes, just like any other employee. Consult with a tax professional to understand the specific tax implications and reporting requirements in your jurisdiction.

6. Documentation and reporting: You will need to follow standard payroll procedures for your children, including providing them with pay stubs, filing payroll tax returns, and issuing W-2 forms at the end of the year.

Top 10 Benefits of S Corporation payroll

Implementing S corporation payroll offers several benefits to business owners. Here are the top 10 advantages of utilizing S corporation payroll:

1. Tax savings: S corporations allow for potential tax savings compared to regular corporations. By paying yourself a reasonable salary and taking distributions, you can potentially reduce your overall tax liability.

2. Avoiding double taxation: Unlike regular corporations, S corporations do not face double taxation. Profits are only taxed at the individual shareholder level, reducing the overall tax burden.

3. Limited liability protection: Operating as an S corporation provides limited liability protection, separating personal assets from business liabilities. This helps protect shareholders' personal assets from being used to settle business debts or legal claims.

4. Flexibility in payroll: S corporations have flexibility in designing payroll structures, allowing for variations in payment frequency and the allocation of income between salary and distributions, as long as reasonable compensation guidelines are followed.

5. Retirement benefits: S corporations can establish retirement plans, such as a 401(k) or Simplified Employee Pension (SEP) IRA, which can offer tax advantages for both the business owner and employees.

6. Social Security and Medicare tax savings: S corporation owners can potentially save on Social Security and Medicare taxes by strategically structuring their compensation. Distributions are not subject to these taxes, allowing for potential savings compared to self-employment taxes.

7. Employee benefits: S corporations can provide employee benefits such as health insurance, retirement plans, and fringe benefits, which can be deducted as business expenses, providing tax advantages for both the business and employees.

8. Transferability and succession planning: S corporations allow for easier transfer of ownership interests, facilitating succession planning and the potential for smooth transitions when selling or transferring the business.

9. Credibility and professionalism: Operating as an S corporation can enhance the professional image and credibility of your business, as it signifies a formalized legal structure and compliance with corporate governance requirements.

10. Business growth opportunities: S corporations can attract potential investors or partners who prefer the structure and benefits of an S corporation, thereby creating opportunities for business growth and collaboration.

It is important to approach this arrangement with transparency and adhere to the principles of reasonable compensation. Tandy Consulting can provide advice tailored to your specific situation and help ensure compliance with all legal and tax requirements.