You work hard as the owner of a business, and you deserve to keep as much of your profits as Uncle Sam will allow. At a certain point in your growth, you may find that filing your taxes as an S Corp could reduce your tax burden and put more money in your pocket.
Filing as an S Corp eliminates the self-employment tax on all income that many small businesses pay, while at the same time keeping some income out of reach of things like Medicare and Social Security taxes. It offers you the opportunity to take part of your income as a W-2 salary, with the associated federal program taxes, and the rest of it as distributions that are not subject to those taxes.
As with most “great deals,” though, there are potential pitfalls. It’s important to take the process seriously and abide by the rules in order to reap the benefits while avoiding some very serious penalties.
Let’s take a look at the benefits and potential pitfalls of filing as an S Corp, and how you can pay yourself in a way that maximizes your tax benefits while minimizing your compliance risks.
TWO COMMON MISCONCEPTIONS
The first common misconception is that distributions are tax free. This is a strangely common misconception. Distributions are essentially dividends, just like a public stock dividend. When Exxon issues you a dividend, you pay income tax on it according to your tax bracket, and when you issue yourself a distribution from your own company, you pay that income tax as well. But the good news is that you don’t pay Medicare and Social Security on top of them
The second misconception is that if you can pay yourself distributions at a lower tax rate, you can pay yourself completely in distributions and avoid paying any FICA taxes at all. A lot of business owners try this strategy every year, and every year many of them get caught and end up paying way more than any tax benefits they thought they were getting.
DON’T MESS WITH THE IRS
The IRS requires you to pay yourself a “reasonable” salary before taking any dividends, specifically to prevent this type of behavior and ensure that the FICA programs receive a reasonable contribution from someone who is claiming to be an employee.
And the IRS watches these numbers pretty carefully. When an individual tax return shows a large percentage of income from distributions and a relatively small one from your W-2, it’s a big red flag. If you get caught, you’re not only looking at back taxes, but a whole pile of extras like interest on back taxes, penalties for failing to file quarterly and annual forms, and penalties for failing to deposit quarterly withholdings.
SET UP A PAYROLL SYSTEM LIKE A BUSINESS WITH MANY EMPLOYEES, EVEN IF YOU ARE THE ONLY ONE
The process for maintaining the paperwork for W-2 employees (you can’t bypass the system with a 1099!) is involved and can be quite tricky. “Employers” must calculate Medicare, Social Security and unemployment taxes and withholdings accurately or risk penalties. You’ll also need to withhold state taxes, account for benefits and bonuses, and file some forms quarterly instead of annually.
If you (or preferably, you and your accountant) determine that the tax benefits of filing as an S Corp outweigh the extra paperwork, you will need to make sure you set up a true payroll system that accurately calculates all withholding obligations and files all the required forms promptly. You can use a bookkeeping service or a recommended app like Gusto, or a combination of the two.
SO HOW MUCH SHOULD YOUR SALARY BE?
According to the IRS, you should pay yourself “an amount that would ordinarily be paid for like services by a like organization in like circumstances.” In the simplest terms, you must pay yourself what the average employee doing the same job, in the same size organization, in the same general location is currently being paid for that job.
To determine that number, the IRS may use a method like consulting a large staffing company in your region to determine a typical or average salary, and that’s essentially what you should do, too. You can find information via the Bureau of Labor Statistics, look up salary estimates on sites like ZipRecruiter or Glassdoor, or pay a company like RCReports that specializes in this area. The important thing is to make an honest effort to get an accurate estimate, then document and save your research and analysis in case the IRS comes knocking.
WHAT IF YOUR BUSINESS DOESN’T MAKE ENOUGH TO PAY A TYPICAL SALARY?
The IRS essentially requires you to pay as much of your salary as possible until the full salary is reached, and only then you can start taking distributions as well.
So, as a very, very basic example, if you determine that your typical salary is $60,000 annually, but your business only made $30,000 this year, you only have to take a salary of $30,000, and you cannot take any distributions. If your business makes exactly $60,000, you must take that salary via your W-2 and are still not eligible to take any distributions. But once your business makes more than your salary, then you can take your salary plus any distributions you like to supplement that salary.
Note that if your business isn’t making enough to pay your determined salary, you may not want to be filing as an S Corp at all. Again, something to discuss with your accountant.
WHAT ABOUT THE 50/50 RULE OF THUMB?
Some accountants will try to simplify things by using a “rule of thumb” like 60/40 or 50/50 salary to distributions, but it doesn’t take much mental effort to see how you could end up shorting yourself by paying too much salary or risking your business by taking too much in distributions. Decades ago, it might have been difficult to determine a fair average salary for a given job, but in the age of the internet it doesn’t take too much extra work to find that information and apply it in your own best interest, balancing tax benefits with enforcement risks.
Filing as an S Corp can be a great way to reduce your personal tax burden, but the process can be fairly complex and the penalties significant, so be sure to do your research and take advantage of all the tools and advisers available to you.