Consultant’s Corner: S Corp Payroll Taxes
Q: I am the sole shareholder and employee of an S-corp. I want to pay myself a wage or salary. How much should I be deducting from my paycheck? What should I do with what I withhold? Do I need software?
S corp owner-officer compensation considerations
When an owner of a corporation (C or S type) or an LLC taxed as a corporation (C or S type) holds executive officer positions (i.e., CEO, CFO, COO, CTO, President, Vice President, Treasurer or Secretary, etc.) with the corporation or LLC, which is common with small corporations and LLCs, and manages the day-to-day business of the enterprise, the owner will generally need to take a W-2 salary in order to comply with the IRS “reasonable compensation” doctrine for corporate officers. C and S corp owners and members of similarly taxed LLCs have considerable discretion in setting their compensation; however, when the business has profits and cash flow they should take W-2 salaries, which are subject to payroll tax withholding and unemployment taxes, and can elect to take after-tax profit distributions in the form of dividend distributions (C corp and similarly taxed LLC) or net income (profit) distributions (S corp and similarly taxed LLC) in addition to their W-2 salaries. Of course, the business must have profits and cash flow, but IRS guidelines require C and S corp owners and members of similarly taxed LLCs who hold executive officer position(s) and manage the day-to-day business of the enterprise to be paid a reasonable amount. Reasonable means that the rate of pay is appropriate for the nature of the work and the qualifications of the worker and you can document that the work was actually performed.
There are no set dollar thresholds that the IRS uses to define whether a corporate/LLC officer’s compensation is reasonable. The determination of reasonable compensation is rather subjective and up to the IRS’ discretion. Generally, what triggers IRS scrutiny is owner withdrawals for dividend or income (profit) distributions and or owner loan payments with the owners taking little or no W-2 salary. In fact, the quickest way for a profitable C or S corp or similarly taxed LLC to face an IRS audit is for the owner-employees to take only dividend distributions (C corp and similarly taxed LLC) or net income (profit) distributions (S corp and similarly taxed LLC) and no W-2 salary. The tax and penalties could be significant if the IRS reclassified withdrawals as W-2 salary in a C or S corp or similarly taxed LLC. We know of no written IRS guidelines on this particular question. Each case is determined based on the facts and circumstances and the IRS can challenge amounts that is considers not reasonable.
As to establishing a salary, there basically is no minimum salary amount prescribed by the IRS for owner-employees of corporations and similarly taxed LLCs, but it’s not uncommon for owner-employees of new corporations and similarly taxed LLCs to defer paying themselves a salary until the business becomes profitable. Also, with an S corp and similarly taxed LLC you have both business and personal tax considerations because of the pass-through tax treatment. A $24,000 annual salary is often suggested by tax practitioners to meet the IRS requirements and this amount may be reasonable in your situation; however, it is common to set a fairly low base W-2 salary—something that you can manage—and supplement it with W-2 bonuses based on profits and cash flow, with any excess profits flowing through to you as distributions.
Employer payroll tax obligations
There are a variety of payroll taxes that must be taken into consideration when a business has employees, including owner-employees: federal Social Security and Medicare taxes, federal income tax, state income tax, in some jurisdictions local (city or county) income tax, in some states disability insurance contributions, federal unemployment tax and state unemployment tax. Also, employers pay the employer’s share of federal Social Security and Medicare taxes as well as federal and state unemployment taxes.
In terms of employee tax withholdings, federal Social Security and Medicare taxes are withheld from an employee’s pay at flat rates of 6.2% and 1.45%, respectively. Employers must also pay the employer’s share of the Social Security and Medicare taxes withheld from their employees’ pay at the same 6.2% and 1.45% flat rates. Social Security taxes are withheld on taxable wages up to the Social Security wage base which is $118,500 in 2015 and 2016. Medicare taxes are withheld on all taxable wages.
Federal income tax withholding from an employee’s pay can vary depending on the employee’s marital status, the employee’s withholding exemptions, and the payroll period. Federal Form W-4, which employers have new employees complete before starting work, is used by employers to gather some of this information and withhold the correct amounts of federal income tax from an employee’s pay. The IRS provides tables and formulas in Publication 15, Circular E, Employer’s Tax Guide, that employers can use to calculate these amounts based on the information found on the employee’s Forms W-4.
Federal and state unemployment taxes are imposed directly on the employer. The federal unemployment tax rate is .6% on the first $7,000 in taxable wages paid an employee.
With respect to year-end tax reporting for employees, a business must provide each employee with a copy of Form W-2 for the preceding calendar year by January 31st and submit copies of Forms W-2 along with Form W-3, Transmittal of Wage and Tax Statements, to the Social Security Administration (SSA) by February 28th. However, you have until March 31st to submit Forms W-2 and W-3 to the SSA if you submit the forms electronically. State requirements vary, but typically, copies of Form W-2 must also be submitted to state taxing authorities along with any required state withholding tax reconciliation return by February 28th. Paper Forms W-2 and W-3 must be submitted to the SSA using machine readable (optically scanned) forms that you can order directly from the IRS at 1-800-TAX-FORM (1-800-829-3676).
Failure to withhold, deposit and report the proper employment taxes can result in severe penalties. To avoid making any costly mistakes and help you develop a better understanding of your business’s tax withholding, reporting and remittance obligations, you will need to review federal and state employer’s payroll tax guides and contact your local accountant, if necessary, to clarify your responsibilities.
Payroll processing considerations
With just yourself as an employee, you should be able to manage your S corp’s payroll processing in-house using your accounting software or possibly a standalone payroll software; however, some employers with limited resources and a lack of accounting expertise find outside payroll services economical and efficient for payroll processing and paying employment taxes. There are other payroll service providers you can research; however, you can review and compare the Payroll & HR Solutions of our service partner ADP in the Resources section of the GSB website and at the following web page link:
Many small business accounting software programs, like QuickBooks for example, do provide some level of payroll accounting and processing functionality. Also, as we discussed above, another option is to use a standalone payroll software; however, with this option, your payroll information will typically need to be input twice, once into the payroll software and then again into your accounting software, unless both programs have import/export capabilities. There are some standalone payroll software programs that sell for under $200 a year, including low cost shareware programs that may suit your needs; however, you will need to research each of these programs to determine if one of them can meet your needs. Again, if you handle both your accounting and payroll in-house, you have to consider that you will also be entering payroll information in your accounting software after-the-fact which is an additional time and therefore opportunity cost consideration.
