How Do S Corporations Run Payroll?

By  //  October 1, 2021

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Many freelancers and entrepreneurs consider S corporations to be some of the most attractive ways of structuring their businesses to obtain fair tax benefits. The main reason for choosing to be an S corporation is that it doesn’t pay tax as an entity. However, payroll issues often arise when trying to take advantage of these savings. 

S Corporations and Payroll

S corporations are businesses that enjoy incorporation benefits without the inconvenience of double taxation. The corporations are separate entities that don’t pay any tax on their earnings. However, shareholders are still required to pay income tax. In addition, shareholder distributions aren’t subject to Social Security taxes and Medicare. 

This leaves the question, why can’t S corporation members take all of their income as distribution? If they work for the business, shareholders are also employees who deserve a salary. Therefore, it is crucial to have a reliable and effective payroll system even if an S corporation only has one employee. 

How S Corporations Run Payroll

The need for running payroll in S corporations is similar to any other business with employees. They run payroll by calculating their unemployment taxes, FICA taxes, and income tax. These figures are based on the wages they earned within a specific pay period. 

One of the most considerable distinctions from large organizations is that their payroll needs are more flexible. This is especially true when there is just one shareholder/employee. In such instances, the individuals may have varying payments. They may even divide their earnings into large but inconsistent payments. 

If your S corporation has trouble running payroll, it may be wise to hire a payroll practitioner. The professional is experienced enough to handle all the hard work while you focus on the business’s primary operations.

Hiring a professional isn’t as expensive as dealing with the consequences of poor payroll management. If your business earns a net profit of over $40,000 every year, your tax savings may be enough to offset the cost of bringing in a professional. 

Determining Reasonable Salaries for the Owners

When determining the appropriate salaries for S corporation owners, the general rule is to give them as much as an employee in the same position would make.

However, the IRS may also use these factors to establish an appropriate compensation:

  • Dividend history
  • Experience and level of training
  • Timing and the mode of paying bonuses to critical people
  • The time and effort dedicated to the business
  • Formulas used for determining compensation
  • Compensation agreements
  • The payments issues to non-shareholder employees

If the IRS determines that an owner didn’t get enough compensation based on these considerations, they may choose to reclassify the received distributions as salary. Therefore, the owner would need to pay back payroll tax on income as well as penalties imposed by the IRS. 

The owners of S corporations can buy compensation analysis reports or compile their own following the Bureau of Labor Statistics guidelines. There are lots of sites with helpful information regarding salaries. 

After establishing an appropriate figure, they may need to make a few tweaks to suit specific circumstances. If an owner is only working for the company part-time, they may choose to lower their salary. If the business isn’t making any income, the IRS doesn’t require owners to pay themselves. 

Using the 60/40 Rule

The 60/40 rule is an approach that the owners of S corporations use to determine their salaries. Using the formula, they can separate their income into two main parts. 60 percent of it goes into wages, and 40 percent falls into shareholder distributions. The S Corp salary 60/40 rule may not be IRS-approved, but many accountants swear by it. 

Payroll Gives the Owner an Advantage In Tax Planning

Having a reliable payroll system is more than just a legal requirement. If you operate as a corp and run payroll, it can be easier to stabilize your income and tax situation. You may find it a bit inconvenient to pay quarterly estimated taxes on your business. Dealing with substantial lump sums increases your risk of overpaying or underpaying.

When running payroll, you can avoid income tax liabilities which helps you save money. Paying your taxes will be more like having a job than running a business. This is an advantage you can’t afford to miss. 

Compliance is one of the biggest challenges that S corporations face, especially when dealing with payroll. Running payroll legitimately is not only a legal requirement but also good for the business. It protects you from legal fees and simplifies the process of paying your taxes.