Are You Paying Yourself Correctly as a Shareholder of an S Corporation?

If you operate your business as an S corporation and pay yourself on a 1099-MISC, then you’re possibly in violation of tax law, which can subject you to substantial tax liabilities and penalties.

The law requires you to pay yourself a salary for the work you do for the corporation. Your salary should be reasonable based upon your position, hours worked, and duties performed. It should also be equivalent to executives or employees in similar businesses. The salary shouldn’t be in the form of distributions or 1099 payments. The payments should be run through payroll to ensure the proper income tax, social security and unemployment taxes are deducted as they are for a non-shareholder employee or a worker in another company. The business can deduct the wages and taxes from income as operating expenses.

You may be tempted to pay yourself as a 1099 recipient, as life seems so much simpler this way — no payroll taxes to deal with, no payroll tax returns to file, and no payroll services fees to pay. However, having your S corporation pay you this way could cost you thousands of dollars in taxes, interest, and penalties! Because this is a violation of tax law, the IRS can reclassify your 1099 payments as W-2 wages and collect the back payroll taxes and interest on the payroll taxes. With the passage of the Tax Cuts and Jobs Act, failure to pay reasonable compensation is no longer just a payroll tax issue. The Act introduced a new deduction that allows shareholders of an S-Corporation, as well as sole proprietors and partners to deduct 20% of the qualified income from their business on their personal returns. However, qualified business income excludes reasonable compensation paid to the shareholder of an S-Corporation. Failure to pay yourself a reasonable salary will falsely inflate the amount of this deduction, which may lead to the IRS to recalculate the amount of your deduction based upon the amount of compensation that should’ve been excluded.

There’s no requirement that an S corporation pay out all its profits to the shareholder as wages. You may be able to apportion the payments between wages and distributions. Distributions are deemed to be a return on the shareholder’s investment. They’re included in a shareholder’s taxable income but aren’t subject to payroll taxes and aren’t considered self-employment income subject to self-employment tax. Determining this apportionment can be tricky, so contact us for assistance.

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