Why do shareholders of S Corp need to be put on payroll instead of a 1099
In order to understand why shareholders of an S Corporation need to be placed on payroll instead of a 1099, you have to understand what an S Corporation is. Basically, it’s a type of corporation established through an IRS tax election. If your company is eligible, then you can avoid being taxed twice, once to the corporation and once to the shareholders, by choosing to be regarded as an S Corporation.
How are S Corporations different?
The main difference between being an S Corporation and a normal corporation is that your profits and losses will go through to the owner’s personal tax return. As a result, the business itself won’t be taxed. Instead, only the shareholders are taxed. Many small businesses choose to be classified as an S Corporation, in part because doing so can help save the owner social security and medicare taxes.
Why shareholders should be treated as employees
Corporate officers are included within the definition of an employee for both the Federal Insurance Contributions Act and the Federal Unemployment Tax Act. This means that shareholders that perform services for the corporation, any compensation that they receive is typically considered wages. S Corporations need to treat this compensation as wages and not as loans or distributions of cash and property to shareholders. This, in turn, means that the shareholder can be treated as an employee.
Because your officers are considered employees for federal employment tax purposes, you should not try to avoid paying employment taxes by having your officers disguise their compensation as payments for personal expenses, loans or cash distributions instead of wages.
By placing shareholders on your payroll instead of on 1099s, it allows your business to save on social security and medicare taxes. This is because these taxes don’t have to be paid on distributions of earnings and profits from your corporation to your shareholders. Basically, you can save a lot of money on your payroll taxes by having your shareholders pay themselves shareholder distributions instead of employee salaries.
One thing that you need to be careful of is not paying your shareholders any employee compensation in order to avoid paying payroll taxes. A large number of single shareholder S Corporations have declined to pay salary to their owners, which resulted in the loss of billions in payroll taxes to the government. The IRS has cracked down on this problem and will audit any S Corporations that pay their owners little to no salaries.
Because of this, any shareholders working for the company will have to pay him or herself fair market value or else the IRS could reclassify additional corporate earnings as wages.
If your company is identified as an S Corporation, then it’s important that your shareholders are put on your payroll. Taking advantage of being an S Corporation can be a bit tricky when it comes to tax planning. If you need assistance with tax planning, or you need general guidance regarding your accounting and bookkeeping, be sure to contact us at Valezar & Associates today.