S Corporations offer a unique tax election that allows business profits and losses to pass directly through to owners' income without being subject to corporate tax rates. However, this tax advantage comes with a specific requirement: S Corp owner-employees must be paid a reasonable salary via payroll.
Understanding the Payroll Requirement
The Internal Revenue Service (IRS) mandates that S Corp owner-employees receive a reasonable salary for services performed for the corporation. This salary must be paid through a formal payroll process, including withholding and remitting federal and state income taxes (if applicable), and Social Security and Medicare taxes (FICA).
A reasonable salary is the fair market salary a business would pay someone else to perform the same duties as the shareholder-employee, based on experience, responsibilities, industry, and location.
Reasons for this Requirement
- Preventing Abuse and Ensuring Fair Taxation: To prevent S Corp owners from avoiding payroll taxes by distributing all profits as tax-advantaged distributions, the IRS enforces a "reasonable salary" rule. This ensures that a portion of the owner's compensation is subject to payroll taxes, similar to other employees.
- Defining Employee vs. Shareholder Roles: As an S Corp owner, you act as both an employee (earning a salary for your work) and a shareholder (receiving distributions from profits). Payroll ensures your salary and investment returns are clearly separated.
- Compliance with Employment Laws: S Corp owners who are actively involved in their business must be treated as employees for payroll purposes to comply with employment laws, including withholding, reporting, and unemployment insurance regulations.
- Supporting Social Security and Medicare Programs: FICA taxes collected through payroll contribute to the funding of Social Security and Medicare programs. The IRS requires S Corp owner-employees to pay a reasonable salary to ensure their contribution to these programs.
At Heard, we'll be glad to help you with a reasonable compensation report that takes these requirements into account. For more, see How do I set a reasonable salary and why is it important? or reach out by sending a New Message.
What happens if you don't issue payroll?
If you are out of compliance with payroll regulations, the IRS can reclassify distributions as wages. Then assess back payroll taxes, penalties, and interest. In extreme cases, this could lead to audits or further legal action.
Best Practice for S Corp Owners
- Pay yourself a reasonable salary first, then take additional profits as distributions.
- Keep a record of how you arrived at your reasonable salary (e.g., industry standards, duties performed).