S-Corporation: Advantages, Disadvantages, and Payroll

 

When considering forming an S-Corporation, it is important to weigh the advantages, such as pass-through taxation and limited liability protection, against the disadvantages, like restrictions on ownership and eligibility requirements. Managing payroll for an S-Corporation involves ensuring compliance with tax laws and regulations, as well as accurately calculating and distributing employee wages. Today we look into the advantages, disadvantages, and payroll setup of an S-Corporation.

What is an S-corp?

An S-Corporation is a type of business entity that allows for pass-through taxation, meaning profits and losses are passed through to the shareholders to report on their individual tax returns. Additionally, an S-Corporation provides limited liability protection for its shareholders, protecting their personal assets from business debts and liabilities. Forming an S-Corp involves filing articles of incorporation with the state and electing S-Corp status with the IRS. This type of business structure is ideal for small businesses looking to minimize their tax liability while still maintaining limited liability protection. Consulting with a tax professional or attorney is recommended to ensure proper compliance with all legal and tax requirements when forming an S-Corporation. They can provide guidance on the specific steps needed to establish and maintain this type of business entity.

What are the advantages and disadvantages of S-Corporation?

S-Corps offer pass-through taxation, limited liability protection, ease of formation, potential tax savings, and flexible profit distribution. They pass profits and losses directly to shareholders, resulting in lower taxes. S-Corps also provide limited liability protection, making their formation simpler than C-Corps. They can avoid double taxation and distribute profits among shareholders without requiring ownership percentage distributions.

S-Corps have restrictions on ownership, strict operational requirements, limited growth potential, and tax treatment of fringe benefits. They cannot have more than 100 shareholders, non-U.S. citizens, or certain entities. S-Corps also face limitations in raising capital and may have restrictions on the deductibility of fringe benefits. Additionally, they must meet eligibility requirements to maintain their status, which could lead to less favorable tax treatment.

How do S-corp owners pay themselves?

S-corporation owners typically pay themselves through a combination of distributions and a salary. The salary they receive should be reasonable and comparable to what similar businesses pay their employees for similar job duties. This process involves setting a reasonable compensation, calculating payroll and taxes based on that salary, filing federal quarterly payroll taxes using IRS Form 941, recording payroll transactions, filing state payroll taxes if applicable, and preparing annual tax returns. They may use the 60/40 rule as a guideline to determine the portion of income allocated to salary versus shareholder distributions.

Importance of Reasonable Compensation

S-corporation shareholders often prefer dividend distributions over compensation payments due to the tax advantages. However, to prevent tax evasion, the IRS mandates reasonable compensation for shareholders providing substantial services. Disputes between the IRS and taxpayers frequently arise regarding what constitutes reasonable compensation.

Factors Influencing Reasonable Compensation

Tax advisers should consider various factors when determining reasonable compensation:

1.      Nature of Business: Profession-based businesses may require higher compensation due to profits relying heavily on personal efforts.

2.      Employee Qualifications and Responsibilities: The shareholder's qualifications, responsibilities, and time devoted to the business should influence compensation decisions.

3.      Compensation Comparisons: Comparing compensation with non-shareholder employees and past years' payments helps gauge reasonableness.

4.      Industry Norms: Benchmarking against comparable businesses within the industry provides valuable insights into appropriate compensation levels.

5.      Profitability Ratios: Analyzing profitability ratios relative to compensation helps ensure fair remuneration for shareholder-employees.

6.      Balance with Distributions: While distributions are permissible, setting compensation above the Social Security wage base mitigates IRS scrutiny risks.

S-Corp distributions vs. salary?

S-Corp distributions are profits passed through the S-Corp to its owner (shareholder), while salary is the money paid to the owner as compensation for their work as an employee of the S-Corp. Distributions are not subject to payroll taxes, while salary is subject to payroll taxes such as Medicare and Social Security. It's important for S-Corp owners to receive a reasonable salary to comply with IRS regulations and avoid penalties.

Can a shareholder forgo both salary and distributions?

While not mandatory, it's advisable for profitable S-corporations to pay reasonable salaries to shareholder-employees. However, shareholders who provide limited services may forgo salary, as evidenced in relevant court cases.

How do S-corporations run payroll?

S-corporations calculate income tax, FICA taxes, and unemployment taxes based on wages earned during a given pay period. They determine a reasonable salary for shareholder-employees, divide the annual figure by the number of pay periods, calculate payroll and taxes accordingly, file federal quarterly payroll taxes using IRS Form 941, record payroll transactions, file state payroll taxes if applicable, and prepare annual tax returns, including Form W-2, Form W-3, Form 1120S, and Schedule K-1. To set up payroll, follow the steps below.

Step 1: Set Up Employer Accounts

Setting up the appropriate employer accounts is essential for running payroll as an S-Corp. These accounts include:

1.      Federal Employer Identification Number (FEIN)

2.      State Tax ID

3.      Unemployment Insurance

4.      Electronic Federal Tax Payment System (EFTPS) Account

5.      Workers’ Compensation

6.      New Hire Reporting Account

Step 2: Determine a Reasonable Salary

S-Corp owners must determine a reasonable salary for the services they provide to the corporation. Factors to consider include the nature of the position, required training and experience, industry standards, and bonus payments.

Step 3: Calculate Payroll Taxes

After determining a reasonable salary, S-Corp owners must calculate and pay various payroll taxes, including FICA taxes, income taxes, and state and federal unemployment taxes. Quarterly payments are recommended to avoid missing deadlines or miscalculating tax amounts.

Step 4: Record Payroll Transactions

Maintaining accurate records of payroll transactions is crucial for S-Corp owners to ensure compliance and avoid issues during tax audits. Transactions should be categorized into wages, payroll taxes, and shareholder distributions.

Step 5: File State and Federal Taxes

S-Corp owners must file various tax forms, including Form 941 for quarterly income and FICA taxes, state unemployment and income tax forms, and annual forms such as Form 940 for federal unemployment tax and Form 944 for small employers.

Final Words

Forming and managing an S-corporation involves working through complex tax laws and regulations. While the benefits of pass-through taxation and limited liability protection can be appealing to small business owners and freelancers, ensuring proper compliance is essential to avoid penalties and legal issues.

By partnering with a tax consultant, small business owners and freelancers can gain peace of mind, knowing that their S-Corp is structured and managed in a compliant and efficient manner. With expert guidance, they can focus on growing their business and achieving their financial goals while minimizing tax liabilities and legal risks.

Given the complications involved in S-Corp formation and payroll management, consulting a tax professional or attorney is highly recommended. A CPA for S-corp can provide valuable guidance on the specific steps needed to establish and maintain an S-corporation, ensuring compliance with all legal and tax requirements.

Disclaimer: This article does not constitute tax advice. Please consult Ahmed Baqir, CPA at Epsilon Accounting Solutions PLLC, before making any tax-related decisions or taking any actions based on the information provided in this article. Ahmed Baqir, CPA, has the expertise and knowledge to provide personalized advice tailored to your specific financial situation and goals.