Running payroll is one of the small businesses most significant ongoing money transactions. Many entrepreneurs aren’t aware of how their business structure will impact payroll processing, which can result in costly fines and penalties if done incorrectly. The IRS has stepped up its scrutiny of how S-corps pay themselves, especially concerning salary versus distributions. Getting paid a reasonable wage is crucial.
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Flexibility
S corp payroll is one of the most consistent and significant money transactions a small business experiences while it’s operational. As such, it needs to be handled correctly and consistently. Having reliable solutions for calculating and processing shareholder-employee payroll payments and tax deposits. S corporations are designed to protect owners from double taxation by allowing them to pass profits through to shareholders without having the entity pay income tax at the corporate level.
This prevents the corporation from paying income taxes on profits delivered to shareholders as dividends. However, the IRS does require that an S corporation pay a reasonable salary to shareholder-employees. To be considered fair compensation, this payment must be based on how much time and effort the shareholder-employee spends on company activities. The corporation must also withhold and deposit employment taxes, including federal income tax, social security tax, and Medicare tax for the employee.
Tax Savings
In most cases, running a business-of-one taxed as an S corporation is a smart way to save on taxes while still getting paid what you’re worth. However, leveraging payroll comes with a lot of responsibility and requires careful record-keeping. While there are many benefits to running an S corporation payroll, the most significant is that it saves on self-employment tax (or FICA taxes).
To take advantage of the benefit, a shareholder-employee needs to be paid a reasonable salary for services performed and must also receive distributions from the company as profits or capital gains. In the case of an S corporation, these profit and capital gain distributions are exempt from payroll taxes as long as they don’t exceed the Social Security wage base. This translates into savings on the 15.3% FICA taxes (Medicare and Social Security) generally payable in addition to regular income tax.
However, it’s important to note that the FICA tax saving has a downside: reducing an owner-employees salary will reduce their future Social Security benefits, as Social Security benefits are based on the average of their highest 35 years of wages. Another thing to remember is that S corp shareholders still need to pay quarterly estimated taxes, just like a traditional employee. These estimates are typically based on the company’s annual net profit and will vary by state.
Increased Cash Flow
A consistent payroll process provides a steady source of cash for your business. This consistency helps manage cash flow and demonstrates to lenders you’re a legitimate and stable company. Furthermore, having a consistent pay schedule is essential as this helps manage employee expectations. For example, your company should pay employees weekly, bi-weekly, monthly, or quarterly, depending on your business’s needs and industry standards.
In addition to payroll tax deposits, your S Corporation must file a federal and state income tax return. You must also obtain a Federal Employer Identification Number (FEIN) and a State Tax ID (if your state requires it). You may also be required to file state or local taxes or even pay unemployment insurance.
Understanding S Corp payroll and how to best utilize it to your advantage is essential. We recommend hiring an accountant or payroll tax service to help you navigate the ins and outs of running your business.
Increased Confidence
As a result of the 2017 Tax Cuts and Jobs Act, S corporations are now taxed at the individual shareholder level, similar to sole proprietorships and general partnerships. However, some things could be improved in this approach. For example, S corp shareholders may pay more taxes due to the flow-through taxation of profits, depending on their income tax brackets. The good news is that there are ways to mitigate this potential issue.
The key is to use a reliable solution for managing shareholder-employee payroll. Another benefit of S corporation payroll is that owners can save on Social Security and Medicare taxes by using the dividend distribution option instead of a salary. This is especially helpful if the business is profitable.
In addition to avoiding higher taxes, paying yourself a monthly salary can help you keep track of company expenses and shows that you’re earning a reasonable wage (per IRS requirements), which is essential when applying for a mortgage or credit card. The IRS requires that your salary be reasonably related to your work and any other duties you assume for your business. To learn more about S corporation payroll and how to maximize its benefits, consult with an expert business advisor.