“S Corp” is a tax designation that offers a number of tax benefits to sole proprietors, LLCs and C-corporations, which is why business owners should familiarize themselves with the requirements for S Corp eligibility and the potential upsides.
To be eligible for S Corp tax designation, an organization must meet the following IRS criteria:
All shareholders must be U.S. citizens or legal residents (individuals, estates, and certain qualifying trusts)
Must be a domestic corporation
Must have no more than 100 total shareholders
Must only have a single stock type; tiered and/or preferred stocks are barred
Cannot be owned by another C Corp, partnership, or LLC
Cannot be an insurance company, domestic international sales corporation, or certain types of financial institutions
To apply for S corporation status, a corporation is required to submit Form 2553, Election by a Small Business Corporation, to the IRS after securing signatures from all corporate shareholders.
Although the process to determine eligibility and acquire S Corps status can be fairly straightforward with professional help, internally managing payroll beyond for an S Corp that point is a more complex and demanding process.
Here, we’ll not only explore the overall benefits of S Corp designation, but also offer guidance on how to thoughtfully manage your S Corp payroll services to maximize tax benefits and ensure long-term compliance. We’ll also help you determine criteria for choosing a payroll service provider and outline best practices for your S Corp payroll.
S-Corp designation provides a number of benefits to business owners and business partners, including asset protection, avoidance of double taxation, improved distribution of federal tax liability, and significant self-employment tax savings.
Let’s explore the upsides of each benefit:
Asset Protection - With S Corp status, business owners and business partners can protect their personal assets from any litigation/legal penalties the business may face.
Bypassing Double Taxation - S Corp shareholders report the flow-through income, losses, and credits passed to them via the S Corp and pay individual income tax on their personal tax returns. As a result, an S corporation is spared double taxation on all corporate income.
Payroll Tax Breaks – An S Corp is only obligated to pay FICA payroll tax on its employment wages while the rest of the corporate profits are exempt from self-employment tax as well as FICA payroll taxes. Only income tax is required for any corporate profits. This is significant when considering FICA-taxable salary vs. profits. For instance, if a single-owner S corporation makes a total of $120,000 in earnings, and $55,000 is set aside for salary (FICA-taxable at 15.3%), the remaining $65,000 is only subject to income tax.
Even with all of these advantages available to S corporations, it can be a challenge for businesses to properly navigate payroll management to gain the most from potential tax benefits and other legal allowances.
An S Corp is responsible for the following and more as it relates to payroll and taxes:
Identifying a qualified payroll provider to assist with these processes ensures that each task is responsibly handled to keep your business protected and provide maximum S Corp tax benefits for your business. In this section, we’ll recommend evaluation criteria as you consider a suitable payroll solution for your S Corp.
Fundamentally, the payroll provider you choose should be able to efficiently manage all of your payroll needs so you can shift focus towards core business tasks. Whether it’s establishing fair salaries, preventing payroll inaccuracies, completing tax calculations, determining pay frequency, or managing shareholder distributions, the right provider will provide the proper guidance, customer support, expertise, and software to keep these processes streamlined and simplified.
The right payroll service for an S-Corp should be able to complete all of the following processes and more:
With an employee salary or combined salary-distribution approach, you are required to create, receive, and report a W-2 that includes your yearly salary and any necessary employment taxes. The IRS requires that any S-Corp employee receives compensation that is on par with comparable roles in the same industry; failure to do so can result in IRS penalties.
As you work with a payroll provider to determine an appropriate salary that is aligned with your designated employee role, they should be able to help you formulate and archive documents that demonstrate how you reached your compensation number in the event of an IRS audit or inquiry.
Another option for owners who are also shareholder-employees is to earn compensation through a combination of a salary and shareholder distributions. In this case, a W-2 and employment taxes are still required for reporting yearly salary, but distributions (cash or stock earnings, typically) are excluded from a variety of taxes, including payroll taxes, FICA taxes, and employment taxes.
Distributions are taxed on the individual income tax return of the shareholder. Bear in mind that if you plan to pay yourself partially or fully through distributions, you must be aware of your organization’s stock basis: the overall amount that you invested in the company. Any amount beyond that number is fully taxable income.
Regardless of which approach you choose for compensation, you will need the support of a qualified payroll provider to follow “reasonable salary” criteria articulated by the IRS, conduct third-party research on comparable salaries in your industry, and create a beneficial balance of salary and distributions that maximizes your compensation and potential tax breaks.
Following broad 50/50 or 60/40 salary-to-distribution ratios can give you a general idea of where to start, but it’s best to consult payroll experts to develop a strategy that works for your S Corp long-term and ensures adaptability in the face of changing regulations and business gains and losses.
Although determining salary and distributions for yourself and other shareholders is a pivotal best practice, you should also gain an understanding of accountable plans, state tax requirements, deductions, health insurance premiums, and payroll tax statements. These are important legal and tax-related requirements that keep your S Corp compliant with regulations and simplify some of your payroll processes.
Transitioning to an S Corp tax designation can be a major benefit to your business. Completing (and routinely managing) the logistical and payroll-related processes is a tall order. That’s why CAVU HCM alleviates the need for in-house payroll management by providing the expertise, customer support, and software to help your S Corp efficiently run payroll, capitalize on a host of tax benefits, and remain legally compliant amid regulatory changes.