Factors to Consider About the S Corp Payroll Taxes
If you’re considering running your business as an S corp, you should know that you have a lot to consider regarding your payroll taxes. These tax considerations are more complex than they are for a C corporation, but they can save you a lot of money in the long run.
Taxes on Distributions
Like all business entities, S corporations must pay their shareholders a reasonable salary for their work. These payments are separate from the distributions and dividends the owners receive. The IRS requires that these amounts be paid out regularly timely manner.
When determining a reasonable salary, S corps use a variety of rules of thumb based on factors such as the net business income and the number of employees. These factors are reviewed periodically based on how well the business is doing.
As with other payroll issues, the IRS takes seriously the S corp owner-employees desire to save on employment taxes. Suppose the IRS determines that the S corporation owner-employee did not receive a reasonable salary. In that case, it can recharacterize the distributions as income and require payment of employment taxes and penalties.
Aside from the actual compensation of an owner-employee, S corporations must also pay a reasonable tax on profits that the shareholders earn through distributions. This amount is often referred to as the pass-through income of the business.
The taxation of S corporation distributions differs from the taxation of other types of pass-through income, such as those earned by partnerships or C corporations. This is because the income of S corporations is taxed to the shareholders only once, instead of being taxed at the partnership or C corporation level.
Taxes on Wages
The S corp payroll taxes are one of the best tax advantages of an S corporation, but they can also cause trouble. While S corporations don’t pay income taxes on business profits, they must still pay their shareholders (owners) wages.
The IRS is strict about S Corp owners who evade employment taxes by disguising distributions from the corporation as “reasonable compensation” for the owner’s services. Often, this can be achieved by splitting the owner/employee’s share of profits between salaries and distributions.
However, reasonable compensation can be a gray area because it depends on the owner’s skills and the services they provide to the company. If you need help determining how much you should pay yourself, talk to your accountant or lawyer.
In general, you want to pay yourself a salary consistent with what other employees in your industry earn. You can find wage data from the Bureau of Labor Statistics to help you make that decision.
In most cases, S Corp owners should use a 50/50 profit split between their salaries and profit distributions. However, a 60/40 rule is another possibility. This approach splits 60% of their salary between taxable wages and S corporation dividends free of FICA taxes.
Taxes on Unemployment Insurance
S corporations with employees must pay most of the taxes traditional corporations pay, including FICA and Medicare taxes. They also pay a federal unemployment tax, which most S corporations pay at a rate of about 6 percent of their employee wages.
Shareholder-employees who work for S corporations report their income and payroll taxes on quarterly IRS Form 941, Employer’s Quarterly Federal Tax Return. They also file a state unemployment tax form.
Many S corporation owners choose to pay themselves as salary or wages, which means that the S corporation’s shareholders/employees don’t have to pay self-employment tax. They also can choose a lower tax rate than their individual tax rates would otherwise require.
In addition, a few states require that S corporations pay state unemployment insurance taxes. This is something that S corps with one or two employees/shareholders don’t have to pay, but it’s an important consideration if you operate in a state requiring this tax payment.
Unemployment benefits are fully taxable in most states, although a few states tax only part of the amount you receive, depending on where you live. Residents in eight states that don’t have a state income tax – Alaska, California, Florida, Nevada, South Dakota, Tennessee, Texas, and Washington – don’t have to worry about paying taxes on these benefits.
Taxes on Social Security
Unlike traditional corporations, S corps must withhold and pay federal Medicare and Social Security taxes on wages paid to employees. In addition, they are required to pay state franchise tax and sales and excise taxes on their business profits.
The payroll tax an S corp pays depends on its size and the number of shareholders. It usually is about 15 percent of an employee’s wages.
Most S corporation owners report their taxable income on IRS Form 941, Employer’s Quarterly Federal Tax Return, and add in the payroll taxes that their S corporation has paid. They may also have to file estimated taxes on their payroll taxes.
One potential issue for S corporation owners is allocating the share of their income that can be considered wages (taxed under FICA) and the shares that are paid out as dividends or distributions (of previously-taxed pass-through income). This cannot be very easy and often involves interpretations of IRS guidance.
One of the best ways to minimize your payroll taxes is to divide your total S corporation earnings between salaries and distributions taxable under FICA. However, you must be careful that the distributions are reasonable concerning your services. If the IRS deems your distributions unreasonable, you will have to pay payroll taxes.