Payroll for S Corporation Owners

If you own an S corporation and you also work in it, you are not just an owner. You are an employee, and the corporation must run payroll for you. Many new S corporation owners are surprised to learn that they cannot simply withdraw profits and skip payroll. This guide explains the payroll side of that rule: who counts as an employee, how much pay is enough, which payroll taxes apply and how owner health insurance is handled.

Why an owner-employee needs payroll

An S corporation is a separate entity. When an officer performs real services and receives or is entitled to payment, the IRS says those payments are wages, and being a shareholder does not change that. An officer who performs only minor services and is not entitled to pay generally would not be an employee.

Courts have found that shareholder-employees owe employment taxes even when the business labels the money as distributions or dividends. A stated plan to keep wages low does not settle the question. The test is whether payments are really pay for services.

Profit that the business earns from its capital, equipment or non-shareholder employees can generally flow out as distributions. Profit that comes from the owner's own personal services supports wage treatment. For the tax side of the entity choice, see S corporation taxes.

What is reasonable compensation

If a shareholder receives or is entitled to cash or property, the corporation must determine and report a reasonable salary. No formula in the law gives a single number. The IRS lists factors it considers, including:

• Training and experience.
• Duties and responsibilities.
• Time and effort devoted to the business.
• Dividend and distribution history.
• Pay to non-shareholder employees.
• What comparable businesses pay for similar services.
• Compensation agreements and the timing of bonuses.

If the IRS finds pay unreasonably low, it can recharacterize distributions as wages, which brings back taxes, penalties and interest. Read more in our guide to reasonable compensation for S corporation owners. Owner wages also interact with the qualified business income deduction, so it is worth planning both together.

Which payroll taxes apply

Owner wages are treated like any employee's wages.

• Income tax withholding based on the owner's Form W-4.
• Social Security and Medicare, both the employee and employer halves.
• FUTA and state unemployment insurance, in most cases. State rules on corporate officers vary, so confirm yours. See state unemployment insurance.
• Deposits and returns: federal deposits, quarterly Form 941, annual Form 940, and Form W-2.
• State income tax withholding, plus any local taxes where the owner works or lives.

Because the owner is on payroll, there is no self-employment tax on wages. Social Security and Medicare are handled through payroll instead.

Example (numbers are illustrative only, not a recommendation of any salary). An S corporation pays its owner-employee $80,000 in wages for the year. Employee Social Security and Medicare are 7.65% x $80,000 = $6,120, and the corporation pays a matching $6,120. FUTA at the usual 0.6% on the first $7,000 is $42. State unemployment tax would be added based on the state's rate and wage base.

Health insurance for 2% shareholders

A shareholder who owns more than 2% of the S corporation is handled differently from other employees for certain fringe benefits. The corporation can pay the owner's health insurance premiums, but the premiums must be reported as wages in box 1 of the W-2. They are not included in boxes 3 and 5, so they are not subject to Social Security or Medicare tax, and the IRS says they are also not subject to FUTA when paid under a plan covering all employees or a class of employees.

The owner may then qualify for an above-the-line deduction on the personal return, subject to the self-employed health insurance rules. The IRS says the corporation must ultimately pay the premiums and report them as taxable compensation for the deduction to be allowed. A related fringe-benefit rule: Publication 15-B states that a 2% shareholder is not treated as an employee for the accident and health exclusion. See fringe benefits and taxable wages.

Common mistakes

• Taking only distributions and issuing no W-2.
• Starting payroll late in the year or paying a catch-up bonus in December.
• Paying personal bills from the corporate account and calling them distributions without recording them correctly.
• Leaving health insurance premiums off the owner's W-2.
• Running payroll but missing the deposits, which leaves the owner personally exposed. See trust fund recovery penalty.
• Forgetting state and local payroll accounts.

How we can help

We help new and existing S corporations set up payroll, document how owner pay was determined, report owner health insurance correctly and coordinate payroll with the business return. See payroll services, business formation and entity selection, and what we do for small business owners. This is general information, not advice for your situation.

Frequently asked questions

General information only, not tax, legal or accounting advice for your situation. Rules, limits and deadlines change; confirm the current rules with the official source or a qualified professional before you act. Reading this page does not create a professional relationship with CPA Tax Payroll and Accounting Corp.