I wrote this for all of you S-Corporation entrepreneur bosses who are questioning if it’s time to finally put yourself on payroll. This one’s for you! And even if you are not yet an S-corp owner but you got business growth and scaling goals, then I highly recommend you keep on reading.
Now let’s get to the nitty-gritty.
As an owner of an S Corp, you can choose to have your money one of two ways: payroll or through shareholder distribution. One of the main differences is that payroll is subject to both income tax and self-employment tax while distributions are exempt from self-employment tax (15.3%) which, by default, is taxed at a lower rate.
It sounds like a no-brainer, right? Why take payroll wages when you can get your money and pay less tax? Well, the IRS says that shareholders must take a “fair and reasonable amount” of their compensation in payroll wages.
As an owner of an S-Corporation, you are a shareholder in your business. Corporate shareholders are eligible to receive cash distributions when the company is profitable The profits in an S-corporation pass directly to the shareholders in proportion to their percentage of ownership in the company. Some S-corporation owners may choose to take as much compensation as possible from shareholder distributions to avoid or reduce payroll taxes.
However, a shareholder in an S-corporation is also considered an employee of that corporation and therefore should be paid a reasonable wage (that’s just tax law yall). You can’t cheat the IRS out the bag! Don’t even try. 🤣
Anyway, as both the owner and employee of your business, S corporation shareholders must also pay federal and state payroll tax and self-employment taxes. A shareholder must also take an amount at or above an average wage for his duties as compensation. Any attempts to bypass this surely draw the ire of the IRS.
I’m talking about fines, back taxes, AND penalties. The state of California is currently going after companies such as Uber and Lyft who could face millions in taxes and penalties for not putting their drivers on payroll. The case is currently in limbo but it’s not hard to imagine the financial chaos that will ensue in the shared-ride industry if CA wins its case. No, you’re no billion-dollar global company, but if you are an S-corp owner not yet on payroll, consider this a friendly reminder to take action.
We talked earlier about a reasonable salary. What exactly is reasonable in the eyes of the IRS? An S-corp shareholder is in complete power of deciding what a reasonable salary is. Of course, there’s no well-explained definition; the IRS wouldn’t want to make things that easy for us. Typically you want to factor in the industry you’re in. What’s the going rate for your job title in your geographic region? How much profit does your company make annually? For example, if you are an expert Graphic Designer in the Bay Area, perhaps you’d make $150,000 if you worked for Facebook. But you are an entrepreneur: you own your S-Corp and the business profits $100,000 annually.
Knowing those facts, you may decide you pay yourself $80,000 and withdraw the remaining $20,000 to yourself through an owner’s distribution. The IRS would deem this as reasonable based on your particular business situation. Of course, this is a super high-level example and oftentimes the details of your business goals impact your payroll salary. When in doubt, refer to your Accountant.
Now that you have the 411 about the difference between distribution and payroll, I hope this helps you make a sound decision…or at least begin thinking about what’s right for you so you can have that conversation with your Accountant.
To more money in our pockets,