One of the hardest topics for new S-Corporation owners to wrap their minds around is the concept of salary. What is it? Why do I need it? How much should I take? Salary is income you receive from your business run as payroll. The IRS requires that S-Corporation officers take a salary so long as they are a profitable business. When you take a salary, you will receive a W-2 each tax year. Your salary does not have to be regularly paid throughout the year and can vary each quarter. Aside from the IRS compliance rules, what are the benefits of salary?
Know your tax liability
Why are you stuck with an unknown tax bill every April? You don’t have to be! A standard employee has federal (and state where applicable) taxes withheld from the paychecks. Officer salary provides you with the same mechanism to pay your tax liability throughout the year. When you take a salary, your federal withholding is based on how you filled out your w-4; with the proper planning, you will not have any large surprises when it comes to tax season.
Business Deduction
Your salary is also a business deduction. Any amounts taken as salary and the employer side of the FICA taxes will reduce your overall pass-through income. This allows you to take a deduction at the first stage of your business, instead of catching up on deductions on your personal tax return. Having a salary on your business financials shows lenders, the IRS, and any interested parties the true cost of your business in relation to your revenue.
Social Security Eligibility
Taking a salary makes contributions to Medicare and social security. It may feel like you have plenty of time to contribute later to these programs, but there are rules you may not know. To be eligible for social security at 62, you must have contributed to social security for a minimum of 40 quarters throughout your lifetime. By filing quarterly payroll, you are paying into the social insurance program allowing you to count those quarters as a part of your eligibility minimums.
Lending Institutions Requirements
Any programs that are dependent on W-2 earnings will be available to you when you take a salary. Although no one could have known that the Paycheck Protection Program was going to be a factor for 2020 – if you took salary as a W-2 in 2019, you were eligible for relief during the pandemic. The amount of relief was determined by the salary that was paid out from businesses (not profits). The higher your salary, the more money is available to you through the PPP.
Other traditional programs operate in the same way as the PPP. Many lending institutions require you a certain amount of W-2 income to qualify to receive mortgages and other loans. The larger your W-2, the better your interest rate and the more money are able to obtain. Having payroll adds to the legitimacy of your business by offering additional supporting government forms substantiating your income.
Retirement Plans
Retirement is another great reason to take a salary. Self-employed retirement programs define their contribution limits based on the amount of W-2 wages taken by S-corp officers. Instead of the traditional 401(k) max of $19,500, S-Corp owners can get up to $56,000 into retirement if they take the proper salary. This also applies to SEP contributions. The more you can put into retirement now, the less ordinary income tax you will pay in the year. You can read more about retirement for S-Corp owners on our blog.
S-Corp Election Protection
Taking a salary protects your S-Corp election. The IRS can revoke your status when you are not following the rule of taking a salary. Or even worse, if the IRS decides you should have taken a salary but you did not, they can impose a penalty of 100% of the payroll taxes. This would mean that you are paying double, plus interest for not following the rules. Taking a salary is an easy solution to avoid problems in the future.
Finally, with the right set up you can have your health insurance premiums come out from your salary. As an S-Corp owner, those payments are not a deduction for the business – but you are allowed to take the self-employed health insurance deduction if they end up on your W-2.
