As the owner of a single owner S Corp business, you've already taken a big step towards optimizing your tax benefits and protecting your personal assets. However, with great power comes great responsibility, especially when it comes to managing payroll.
Failing to navigate the complexities of S Corp payroll properly can lead to a trifecta of trouble: tax audits, penalties, and fines. We understand that you didn't start your business to become a payroll expert–processing payroll is just one of the many hats you wear as a small business owner. We’ve heard from clients who switch to our service that after a while, it feels like a necessary evil.
But phoning in your S Corp payroll efforts can come back to haunt you down the line.
With the myriad of regulations, taxes, and paperwork involved in small business payroll, it's all too easy to make a mistake that could cost you big time.
In this blog, we'll walk you through the five common missteps of single owner S Corp payroll, from understanding how to pay yourself a reasonable salary to avoiding common pitfalls and staying on top of essential tax filings.
Single Owner S Corp Payroll Basics
Before we can discuss the mistakes single owner S Corporations make during payroll, it’s essential to understand the advantages of this business setup, smart ways to pay yourself as a small business owner, and the potential implications of these options.
Operating as a single owner S Corporation has several advantages. Registering as an S-Corp avoids double taxation by labeling the business a pass-through entity.
- This means you’re not considered self-employed as an owner, and can avoid paying self-employment taxes.
- S Corps also help business owners protect their assets from potential business-related lawsuits.
S Corp owners can also receive dividend payments in addition to a fair salary. These payments are not subject to self-employment taxes, meaning you can deduct them from wages paid when calculating the income passed through to shareholders, which provides valuable tax and payroll benefits.
Options for Payment
Another advantage is that S-corp owners can choose how they want to pay themselves and receive dividend payments in addition to a fair salary. The two payment options are salary or shareholder distributions, both of which offer unique advantages.
- Salary: If they perform more than minor services for their S Corp, they're considered an employee and must pay themselves a reasonable wage. This salary is subject to payroll taxes (Social Security and Medicare taxes).
- Shareholder Distributions: After paying themselves a salary, owners can take the remaining profits as shareholder distributions.
- These dividends are not subject to payroll taxes, making them a tax-advantaged form of compensation. However, owners must first take a reasonable salary.
The IRS requires S Corp owners who are also employees of that business to earn a "reasonable salary" like what similar companies would pay for the same work. Factors to consider include:
- Their role, duties, and time devoted to the business
- Training and experience required for their position
- What comparable businesses pay for similar roles
- Company revenue and dividend history
Some CPAs or accountants recommend a 60/40 rule of thumb, which is 60% of profits to salary and 40% to distributions, but this isn't IRS-approved. As an S Corp owner, you should research salaries for your role to figure out a fair and workable range.
Now that we understand some of these basics, let’s explore five common missteps to avoid when setting up your single-owner S Corp payroll and business structure.
1. Neglecting an Accountable Plan
As a new single owner S Corp, one mistake you might make is failing to set up an Accountable Plan. This plan allows you to reimburse yourself for business expenses and shift the deduction from your personal taxes to your S Corp.
What is an Accountable Plan? An Accountable Plan is a reimbursement arrangement where the company reimburses employees (including the owner) for business-related expenses. These expenses are then deducted from the company’s taxable income, which can lead to significant tax savings.
Key Requirements:
- Business-related Expenses: Ensure the expenses are directly related to your business activities.
- Documentation: Maintain thorough records and receipts for all reimbursed expenses.
- Timely Reimbursement: Submit expense reports and receive reimbursements in a timely manner, usually within 60 days of incurring the expense.
- Excess Reimbursements: Any excess amounts must be returned to the company within a reasonable timeframe (typically 120 days).
Benefits of an Accountable Plan:
- Tax Savings: Shifts the deduction from your personal taxes to the S Corp, reducing your personal taxable income.
- Compliance: Ensures you are compliant with IRS regulations, minimizing the risk of audits and penalties.
- Clarity and Organization: Keeps your business and personal expenses separate, simplifying your financial records and tax filings.
Having an Accountable Plan in place provides peace of mind in case of an IRS audit and helps you maximize your tax benefits.
2. Improperly Reporting Health Insurance Premiums
If you're paying your own health insurance premiums (via an HSA or flexible savings account) as an S Corp owner, it's crucial to report them accurately on your tax return. Include the amount your company paid for your premiums as wages in Box 1 of your W-2. This allowance lets you deduct the premiums on your personal returns.
How to Report Health Insurance Premiums:
- Include on W-2: Report the health insurance premiums paid by your S Corp as wages in Box 1 of your W-2. This makes the premiums subject to income tax but not to Social Security and Medicare taxes.
- Avoid Box 3 and 5: Do not include the premiums in Box 3 or Box 5 of the W-2, as this would subject them to Social Security and Medicare taxes, reducing your tax benefit.
Benefits of Proper Reporting:
- Tax Deduction: By including the premiums in Box 1, you can deduct the premiums on your personal tax return, which lowers your overall taxable income.
- Compliance: Ensures that you are following IRS guidelines and avoiding potential penalties.
Pro Tip: Consult with a tax professional or CPA to ensure that you are correctly reporting your health insurance premiums and maximizing your tax benefits. ConnectPay can connect you with a local professional who knows the laws and benefits in your area.
3. Over- or Under-utilizing Home Office Deductions
Claiming a home office deduction can provide significant tax savings for S Corp owners, but it's essential to follow the rules. Your home office must be your primary place of business and used exclusively for work. You can deduct a percentage of your utilities, rent, and insurance based on the square footage of your office relative to your home.
Eligibility Requirements:
- Primary Place of Business: Your home office must be your principal place of business or a place where you meet with clients or customers regularly.
- Exclusive Use: The space must be used exclusively and regularly for business purposes.
Calculating the Deduction:
- Simplified Method: You can deduct $5 per square foot of your home office, up to a maximum of 300 square feet.
- Actual Expense Method: Calculate the percentage of your home used for business and apply that percentage to your home-related expenses (utilities, rent, mortgage interest, insurance, etc.).
Common Mistakes:
- Over-Claiming: Claiming more space or expenses than is reasonable or not used exclusively for business can trigger an audit.
- Under-Claiming: Not taking full advantage of the deduction, thereby paying more in taxes than necessary.
4. Paying Too Much or Too Little in Salary
One challenge of running an S corporation is determining a reasonable salary. The IRS expects you to pay yourself a fair wage based on factors like your qualifications, time invested in the business, and industry standards.
Underpaying yourself might trigger a payroll compliance audit while overpaying can lead to higher self-employment taxes. Aim to find a balance that fairly compensates you for your work while optimizing your tax situation.
Factors to Consider:
- Role and Duties
- Industry Standards
- Company Performance
Consider the following questions:
- Does your position require training?
- How much time and effort is required for this position?
- How much experience is typically required for this or similar positions?
- What are the going salaries for this or similar positions?
- Does this position receive any non-salary bonus payments?
Risks of Incorrect Salary:
- Underpaying: This might trigger a payroll compliance audit and result in the reclassification of distributions as wages, leading to penalties and back taxes.
- Overpaying: Leads to higher payroll taxes (Social Security and Medicare), reducing the tax advantage of S Corp status.
Guidelines and Best Practices:
- 60/40 Rule: While not IRS-endorsed, some CPAs recommend paying 60% of profits as salary and 40% as distributions.
- Consult a Professional: Talk to a payroll professional or CPA to determine an appropriate salary and ensure compliance with IRS guidelines.
Pro Tip: Not sure how to find that balance? Our payroll expertscan connect you to a local CPA partner to answer your questions and make sure your single owner S Corp salary sets you up for success.
5. Missing Payroll Tax Deadlines
After establishing your salary, you'll need to run payroll and make timely tax payments. This process involves completing a W-4, choosing a payroll schedule, calculating taxes, and making monthly payments.
Key Steps to Ensure Compliance:
- Complete a W-4: Ensure all necessary information is filled out accurately.
- Choose a Payroll Schedule: Decide on a payroll frequency (weekly, bi-weekly, monthly) that works best for your business.
- Calculate Taxes: Accurately calculate federal, state, and local payroll taxes.
- Make Timely Payments: Ensure that tax payments are made on time, typically monthly or quarterly, depending on what you owe.
Common Pitfalls:
- Missed Deadlines: Failing to make tax payments on time can result in significant penalties and interest charges.
- Calculation Errors: Incorrectly calculating payroll taxes can lead to underpayment or overpayment issues.
Pro Tip: To avoid missed deadlines or errors, consider partnering with a payroll service like ConnectPay. We’ll handle the complexities of payroll taxes, giving you more time to focus on growing your business.
We Understand S Corps
Managing your single-owner S Corp payroll can feel overwhelming, but it doesn’t have to be. Understanding the missteps you need to avoid to manage your payroll effectively is an excellent starting point to help make sure that your business runs smoothly through tax season and beyond.
However, there’s more to running an effective payroll than simply avoiding disaster. Whether you’re planning to grow your business or keep it as a single-owner entity, you may want to arm yourself with more information about how to manage payroll for your small business properly.
Explore our resource, the Connected Guide for Small Business Payroll, for more information, or book your free 7-minute Payroll and Tax Compliance Review with our team of experts. Are you ready to simplify payroll?
