An S Corp (or S Subchapter) is a corporation that allows businesses to reap the rewards that come along with incorporation while also receiving the tax-exempt status that comes from a partnership. While there are strict initial requirements that companies must meet to qualify as an S Corp with the Internal Revenue Service (IRS), these businesses must continue to adhere to the mandates of an S Corp afterward. This is especially true for payroll, as the IRS is known to scrutinize employee payments under this tax formation. If not done correctly, an S Corp risks losing its status and can face fines or legal troubles for failure to comply. To ensure the right amount of payroll from an S Corp, business owners should follow these guidelines for small business accounting methods:
1. Employee Salary Must Be Reasonable for the Position and Industry
One of the biggest red flags the IRS spots with S Corps and payroll is a salary that is exceptionally low for the position or industry. Most times, S Corps are small businesses. While there can be multiple employees under this formation, most S Corps have one owner who also acts as an employee, and the salary should reflect this status. If the company is profitable but the salary doesn’t add up or is otherwise not in line with industry averages, it can indicate that the owner is disguising their actual salary to avoid payroll taxes. Often, this happens by reporting payments as corporate distributions when they should be taken as payroll. Be sure to research the average salary for the position and industry when determining how much payroll to take from an S Corp.
2. Explore the 50/50 Rule Used by Small Business Accounting Firms
If an owner is having a hard time determining how much of the S Corp profits to take as payroll and how much can be taken as corporate distributions, they should use the 50/50 rule. Many small business accounting firms make use of this strategy when handling S Corp accounts for their clients. It consists of claiming 50% of the earnings as an employee salary and the remaining 50% as corporate distributions. This is a helpful formula to use when S Corps make significantly more or less than the average company in their industry. Despite this, the formula is considered a general guideline and may not apply to all S Corps. An owner who is unsure if it applies to their situation should consult a knowledgeable accountant before making any drastic changes.
3. Look at Other Factors That Affect Payroll
For someone working full time as a business owner, their “reasonable” salary would likely differ from what it would be if they worked at the S Corp part-time. An owner should consider the number of hours they work and the roles they fill in the organization when determining how much to pay themself. Likewise, they should keep any other income in mind. If the individual is an S Corp owner and employee, and they have another full-time job at a different corporation, their status can make the overall income excessive. The IRS may declare that they need to take any income generated from the S Corp as dividends instead of payroll.
4. Consider If There Other Employees or Shareholders
Around 70% of S Corps have only one employee who is the owner. However, if an owner's S Corp has other employees or shareholders, they must ensure that the distributions and salaries are in line with one another. For an S Corp with a second shareholder, the amount received as corporate distributions should be equal. Likewise, an owner with multiple employees should determine those salaries using a similar formula or set of criteria, although the pay rate may differ based on experience, workload, and position.
5. Keep All Employee Compensation in Mind
While monetary income is often the most discussed form of employee compensation, it doesn’t end there. Other types of employee compensation could include bonuses, vacation time, or health insurance premiums. Owners should consider all these factors when deciding how much to pay themself from the S Corp. Equally important, they should track how they arrive at the final figure (including any other forms of compensation as an employee) so they have a well-documented record and an explanation if issues arise with the IRS.
Although an S Corp owner can avoid the cost of self-employment taxes, there are many other requirements owners must meet to remain compliant with the IRS guidelines and retain the tax status.
If you feel unsure about how much payroll you should take, consult our small business accounting expert. This can save you a lot of time and frustration and ensure that you do not unknowingly go against the IRS payroll requirements for an S Corp.