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December 8, 2020

Why Payroll?

Why Payroll?

When you take the S-Corporation election with the IRS, you are agreeing that you will play by the rules. Although it feels complex, it is simple!  One of these rules is that you will pay yourself a reasonable salary.  Payroll can seem complex, but knowing these basic facts help make it a simple and easy part of your business operations.

Reasonable Compensation

The number one requirement for being an S-Corporation is that you take reasonable compensation, a fancy word for payroll or salary.  Reasonable compensation means you are paying yourself the same amount you would pay someone else to perform the same job.  The IRS takes into consideration your experience, education, skill level, and the time you spend performing services for the company as well as industry wage standards to determine if your salary is reasonable.

Because you are an S-Corporation, you will pay self-employment taxes on your salary, not on the overall profits of the company.  This is one of the ways we help ease the tax burden for you!  The IRS does not want you to pay yourself less than you would pay someone else, as this could allow you to avoid paying your fair share of self-employment taxes.  On the other hand, you do not want to pay yourself too much and jeopardize your ability to fund day-to-day operations or over-inflate your business expenses.  It can be tricky to determine what is a fair and reasonable wage that will stand up to any scrutiny from the IRS.

This is one of the things we specialize in at Formations and we are here to help.  As part of our overall service to you, we can provide a reasonable compensation study.  The results of this study help to provide us with a statistically defendable position for the amount we have determined is a reasonable salary for your industry based upon the many hats approach that is allowed by the IRS.  You can be comfortable knowing that we have you covered.

Five Payroll Facts

Here are the top five facts you should know when it comes to payroll:

  1. Payroll is not optional for S-Corps. Failing to take payroll jeopardizes your S-election. If the IRS determines that your salary is not reasonable, they can reclassify a portion of the business income as wages.  This would mean additional payroll taxes, additional federal taxes on your personal return, and the potential for penalties and interest for under-reporting your taxes.  The IRS requires that you pay this reasonable compensation to all shareholder-employees before making non-wage distributions.

    Let us look at this in a logical manner.  As an S-Corp, you are no longer subject to paying self-employment taxes on the profits, or distributions, of your company.  However, to ensure that you are not avoiding paying self-employment taxes entirely, the IRS requires that all shareholder-employees receive a reasonable salary.  You do pay self-employment taxes on this salary by paying both the employer and employee portion of Social Security and Medicare.  So, there is a fine balance in determining what is reasonable and fair and what would be considered too low or too high of a salary.
  2. Correct payroll depends on many complex factors, but minimums are a safeguard.  It can be hard to determine at the beginning of the year, how much income the business will generate, and what is a realistic amount to pay yourself.  It is best to determine a minimum salary at the start of the year, paid on a monthly or quarterly basis.  Your team at Formations can adjust your salary and withholdings when we review your books each quarter.  We recommend a minimum of $60,000 a year in profits before taking the subchapter S-Corporation election.  This ensures you have the revenue to pay a reasonable salary and the subsequent payroll taxes without unnecessarily burdening the daily operations of the company.
  3. Payroll is the only place you pay your self-employment taxes, which consist of your fair share of Social Security and Medicare.  These taxes, known as FICA, are paid by both the employee and the employer.  Wage withholdings of 7.65% cover the employee portion of self-employment taxes.  The employer portion, also imposed at a rate of 7.65%, is a business expense.  On the bright side, this does mean you are contributing to your Social Security Retirement through these payroll taxes.  Remember, the profits of the S-Corporation will flow through to the shareholders and are not subject to these self-employment taxes.
  4. If you have income fluctuations, you do not have to take a payroll every month. To be on the safe side, and keep our IRS friends happy, we recommend taking payroll at least once a quarter.  We can look at the overall income the business generates each quarter and determine a reasonable salary that still allows funding for business operations.  This makes budgeting for payroll taxes easier and ensures your annual tax liability is covered with federal payroll tax withholdings.  And, most payroll taxes are filed and paid on a quarterly basis, so this makes for a streamlined process.  Another benefit to quarterly payroll is that it allows us to determine if any estimated taxes need to be paid due to other income-generating sources in your overall tax situation, such as a spouse’s wages or investment income.
  5. As a bonus, your retirement contribution limits are tied to your total salary for the year. The amount you can contribute to your retirement changes every year.  For 2020, the basic limit for elective deferrals is $19,500 or 100% of your compensation, whichever is less.  This means that you can ensure that the amount you pay yourself in salary allows you to maximize your retirement contributions.  Designing the proper payroll allows you to save for your future!

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