Do I Need to Run Payroll for an S Corp?

The S-corporation (S-corp) structure offers tax benefits and limited liability protection. A common question for owners is how to pay themselves, specifically concerning payroll. Understanding these requirements is crucial for maintaining compliance with tax regulations and avoiding penalties.

The S-Corporation Owner’s Compensation Requirement

The Internal Revenue Service (IRS) requires S-corporation owners who perform more than minor services for their business to pay themselves “reasonable compensation” in the form of wages. This prevents owners from circumventing payroll taxes by classifying all income as distributions, which are not subject to Social Security and Medicare taxes. If the IRS determines compensation is unreasonable, it can reclassify distributions as wages, leading to back taxes and penalties.

Determining reasonable compensation is not a fixed formula, but a flexible assessment considering various factors. The IRS defines it as the amount typically paid for similar services by comparable businesses under similar circumstances. Factors include the owner’s training and experience, duties and responsibilities, time and effort devoted to the business, volume and complexity of business handled, individual achievements, and company compensation policies.

The IRS also considers compensation paid to non-shareholder employees in similar roles within the company or in comparable businesses. Historical salary data for the shareholder and industry standards for equivalent services are significant in this assessment. Documenting how the reasonable compensation amount was determined is advisable to justify it in case of an IRS audit. Some accountants may use a 60/40 rule, but this is not an IRS-approved formula and should not be the sole determinant.

Distinguishing Owner Salary from Distributions

S-corporation owners receive compensation in two ways: as a salary and as shareholder distributions. Salary represents the “reasonable compensation” paid for services rendered, similar to how any other employee is paid. This salary is subject to federal income tax withholding, as well as Social Security and Medicare taxes (FICA taxes).

FICA taxes include both an employee portion and an employer portion, totaling 15.3% on wages up to the Social Security wage base, plus 2.9% for Medicare on all wages. The S-corporation withholds the employee’s share of FICA and income taxes from the salary and remits both the employee and employer portions to the government. This salary income is reported to the owner on Form W-2, Wage and Tax Statement, at year-end.

Shareholder distributions are payments made to owners from the S-corporation’s profits after reasonable compensation and business expenses are covered. These distributions are not subject to payroll taxes, providing a tax-efficient way for owners to receive additional funds. Distributions are typically tax-free to the extent of the shareholder’s stock basis; amounts exceeding basis may be taxed as capital gains.

The S-corporation reports these distributions, along with the owner’s share of the company’s income, deductions, and credits, on Schedule K-1 (Form 1120-S). This income passes through to the shareholder’s personal tax return (Form 1040) and is subject to individual income tax. The primary benefit of an S-corp structure is that profit distributions, unlike salary, are not subject to self-employment tax, provided a reasonable salary has been paid.

Setting Up and Managing S-Corp Payroll

Implementing payroll for an S-corporation owner involves several steps to ensure federal and state compliance. First, obtain an Employer Identification Number (EIN) from the IRS if the business does not already have one. This number is essential for tax filings, bank accounts, and payroll.

Once an EIN is secured, the S-corporation must understand its federal tax withholding obligations for income tax, Social Security, and Medicare. Employers are required to deposit these withheld taxes, along with their own share of FICA taxes, to the IRS. Federal tax deposits must be made electronically, typically through the Electronic Federal Tax Payment System (EFTPS).

Regular federal payroll tax forms must be filed, including Form 941, Employer’s Quarterly Federal Tax Return, which reports federal income, Social Security, and Medicare taxes. Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, is filed annually for federal unemployment taxes. At year-end, the S-corporation must issue Form W-2 to the owner-employee, summarizing their wages and withheld taxes, and transmit these forms to the Social Security Administration with Form W-3.

Beyond federal requirements, businesses also face state and potentially local payroll tax obligations, which vary significantly by location. These may include state income tax withholding, state unemployment insurance (SUI) taxes, and other local taxes. To manage payroll effectively, S-corporations can choose to handle it manually, use payroll software, or hire a professional payroll service. Payroll software automates calculations and form generation, while full-service payroll providers handle all aspects of payroll, including tax filings and deposits, offering a higher level of compliance assurance.