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You are here: Home > Taxpayers Guide to LLCs and S Corps > Chap 10 - Operating Your S Corp > Processing S Corp Payroll

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  • Taxpayers Guide to LLCs and S Corps

    • Introduction

      • About the Author
      • Progressive Updates
      • Introduction Disclaimer
      • Shameless Self-Promotion
      • Book Introduction
      • Quick Reference 2021
      • Quick Reference 2022
    • Chap 1 - Business Entities, LLCs

      • Basic Business Entities
      • Sole Proprietorship
      • Single Member Limited Liability Company
      • Multi-Member Limited Liability Company
      • Partnerships
      • C Corporations
      • Professional Corporations and LLCs
      • S Corporations
      • Section 199A Qualified Business Income Tax Deduction
      • S Corp Versus LLC
      • LLC Popularity (Hype)
      • Formation of an LLC or S Corp
      • Nevada Fallacy of an LLC
    • Chap 2 - Customized Entity Structures

      • Your Spouse as a Partner (Happy Happy Joy Joy)
      • Family Partners
      • Holding Company and Operating Company
      • Parent-Child Arrangement (Income Flows "Up")
      • Parent-Child Arrangement (Income Flows "Down")
      • Multi-Member LLC That Issues Invoices
      • Things to Work Through with Multiple Entities
      • Recap of Benefits with Multiple Entities
      • State Apportionment with Multiple Entities
      • California Multi-Member LLC S Corp Twist
      • Economic versus Equity Interests
      • Structuring Deals with Angel Investors
      • ESOPs and S Corporations
      • Another Employee Ownership Situation
      • Medical C Corp
      • Fleischer Tax Court Case
      • Joint Ventures
      • Loans or Capital Injections
      • Using a Trust in Your Formation Considerations
      • Operating Agreements
      • Exit Plans, Business Succession
      • Liability Protection Fallacy of an LLC
      • Charging Orders
      • Using a Self-Directed IRA to Buy a Rental, Start A Business
    • Chap 3 - S Corporation Benefits

      • Avoiding or Reducing Self-Employment SE Taxes
      • Tax Savings with Health Insurance
      • S Corp Hard Money Facts, Net Savings
      • Officer Compensation with Solo 401k Plan Deferral
      • W-2 Converted to 1099
      • Net Investment Income, Medicare Surtax and S Corps
      • Three Types of Income
    • Chap 4 - The 185 Reasons to Not Have an S Corp or LLC

      • Chapter 4 Introduction
      • Additional Accounting Costs
      • Additional Payroll Taxes
      • SEP IRA Limitations
      • Trapped Assets
      • Distributing Profits, Multiple Owners
      • Other W-2 Income
      • State Business Taxes (Not Just Income Taxes)
      • Deducting Losses
      • Distributions in Excess of Shareholder Basis
      • Stock Classes
      • Vesting and Expanding Ownership
      • Bad Loans to the S Corp
      • Social Security Basis
      • Payroll Taxes on Children
      • C Corp to S Corp Problems
      • Going Concern
      • Recap of S Corp Downsides
      • Growing Business, Debt Service
    • Chap 5 - State Nexus Problems

      • Chapter 5 Introduction
      • Chapter 5 Disclaimer
      • Wayfair Case Part 1
      • Nexus Theory
      • Constitutional and Legislative Standards
      • Sales and Use Tax, Income Tax
      • Physical and Economic Presence, Nexus Attached
      • Wayfair Case Part 2
      • Services and Tangible Personal Property (TPP)
      • Costs of Performance, Market-Based Approach
      • Allocation and Throwback
      • FBA, Drop Shipments, Trailing Nexus Revisited
      • Recap of State Tax Issues
      • State Tax Issues and Nexus
    • Chap 6 - S Corporation Election

      • Formation (Election) of an S-Corp
      • Electing S-Corp Filing Status, Retroactive for 2022
      • Another Option, Dormant S Corp
      • Missing Payroll, Now What
      • Mid-Year Payroll
      • Nuts and Bolts of the S Corp Election
      • Ineffective S Corp Elections
      • S Corp Equity Section
      • Terminating S Corp Election
      • Distributed Assets
      • 5 Year Rule
      • Life Cycle of an S Corporation
    • Chap 7 - Section 199A Deduction Analysis

      • Section 199A S Corp Considerations
      • Calculating the Qualified Business Income Deduction
      • Section 199A Defining Terms
      • Specified Service Trade or Business (SSTB) Definitions
      • Trade or Business of Performing Services as an Employee
      • Services or Property Provided to an SSTB
      • Section 199A Deduction Decision Tree
      • Section 199A Reasonable Compensation
      • Section 199A Pass-Thru Salary Optimization
      • Cost of Increasing Shareholder Salary
      • Section 199A Rental Property Deduction
      • Negative Qualified Business Income
      • Qualified Property Anti-Abuse
      • Aggregation of Multiple Businesses
      • Section 199A W-2 Safe Harbors
      • Additional Section 199A Reporting on K-1
      • Section 199A Frequently Asked Questions
    • Chap 8 - Section 199A Examples and Comparisons

      • S Corp Section 199A Deduction Examples
      • Section 199A Side by Side Comparisons
      • Section 199A Basic Comparisons
      • Section 199A Health Insurance Comparison
      • Section 199A 200k Comparison
      • Section 199A 250k Comparison
      • Section 199A Specified Service Business Comparison Part 1
      • Section 199A Specified Service Business Comparison Part 2
      • Section 199A Phaseout
      • Section 199A Recap
      • Section 199A Actual Tax Returns Comparison
    • Chap 9 - Reasonable Shareholder Salary

      • IRS S Corp Stats
      • Reasonable S Corp Salary Theory
      • IRS Revenue Rulings and Fact Sheet 2008-25
      • Tax Court Cases for Reasonable Salary
      • Risk Analysis to Reasonable Shareholder Salary
      • Reasonable Salary Labor Data
      • Assembled Workforce or Developed Process Effect
      • RCReports
      • W-2 Converted to 1099 Reasonable Salary
      • S Corp Salary Starting Point
      • Multiple Shareholders Payroll Split
      • Additional S Corp Salary Considerations
      • Reasonable Salary Recap
    • Chap 10 - Operating Your S Corp

      • Chapter 10 Introduction
      • Costs of Operating an S Corp
      • New S Corp Puppy, What Do I Do Now
      • Accounting Method
      • 1099-NEC Issued to Your SSN
      • Take Money Out of the S Corp
      • Processing S Corp Payroll
      • Taking Shareholder Distributions
      • Reclassify Shareholder Distributions
      • Accountable Plan Expense Reimbursements
      • Accountable Plan Requirements
      • Shareholder Distributions as Reimbursements
      • S Corp Tax Return Preparation
      • Distributions in Excess of Basis
      • Minimize Tax or Maximize Value (Economic Benefit)
      • Tracking Fringe Benefits
      • Other Tricks of the Trade with S Corps
      • Adding Your Spouse to Payroll
      • Chap 10 - Comingling of Money
    • Chap 11 - Tax Deductions, Fringe Benefits

      • Chapter 11 Introduction
      • Four Basics to Warm Up To
      • Section 199A Deductions – Pass Through Tax Breaks
      • 185 Business Deductions You Cannot Take
      • Depreciation
      • Small Business Tax Deductions Themes
      • Value of a Business Tax Deduction
      • Deductions the IRS Cannot Stand
      • Automobiles and LLCs, S Corps
      • Business Owned Automobile
      • Section 179 and Bonus Depreciation
      • You Own the Automobile, Get Reimbursed By The Mile
      • You Own the Automobile, Take Mileage Deduction
      • You Own the Automobile, Lease Back to Your Company
      • Automobile Decision Tree
      • Home Office Deduction
      • Tax-Free Rental of Your Home
      • Tax Home
      • Business Travel Deduction
      • Deducting Business Meals
      • Sutter Rule
      • Cohan Rule
      • Capital Leases versus Operating Leases
      • Putting Your Kids on the Payroll
      • Educational Assistance with an S-Corp - Section 127
      • Summary of Small Business Tax Deductions
      • Comingling of Money
      • Reducing Taxes
    • Chap 12 - Retirement Planning

      • Retirement Planning Within Your Small Business
      • Self Employed Retirement Plan Basics
      • Retirement Questions to Ask
      • Tax Savings and Tax Deferrals
      • Using a 401k in Your Small Business Retirement Options
      • The Owners-Only 401k Plan
      • Having Staff with a Solo 401k Plan
      • Self-Directed 401k Plans
      • Traditional 401k (A Company Sponsored Plan)
      • 401k Plan Safe Harbor Provision
      • 401k Plans with Roth Option (Roth 401k)
      • Two 401k Plans
      • Rolling Old 401k Plans or IRAs into Your Small Business 401k Plan
      • 401k Loans and Life Insurance
      • 401k Plans and Roth IRA Conversions
      • Turbo Charged 401k Plans
      • SIMPLE 401k
      • SEP IRA
      • SEP IRA, Roth IRAs and the Roth Conversion
      • Controlled Groups
      • Owner Only 401k Plans in MMLLC Environment
      • Non-Qualified Deferred Compensation Plan
      • Exotic Stuff
      • Expatriates or Expat Tax Deferral Planning
      • Small Business Retirement Planning Recap
      • Personal Defined Benefit Plan
    • Epilogue

      • WCG Fee Structure
      • More About WCG
      • Consultative Approach
      • Core Competencies
      • No BS
      • Expectations of Our Clients
      • Final Words
      • Tax Consultation Business Advising, S Corp Consult
    • Chap xx - Health Care

      • Disclosure and Updates
      • Gaming the HSA System
      • Health Care Summary
      • Health Savings Accounts (HSAs)
      • Long-Term Care
      • Multiple Employees
      • One Person Show or Husband-Wife Team, S Corporation
      • Section 105 Health Reimbursement Arrangement (HRA)
      • Section 125 Cafeteria Plans and Flex Spending (FSA)
      • Sole Proprietors and Single Member LLCs
    • Chap yy - Business Valuations, Sale, Exit Planning

      • Business Valuation Techniques
      • Buy-Sell Agreements
      • Deal Structure
      • Debt Service
      • Exit Plans, Succession
      • Purchase Price Allocation
    • Chap zz - Other S Corp Thoughts

      • 1099 Income as Other Income, No Self-Employment (SE) Taxes
      • Audit Rates and Risks with an S-Corp
      • Recap of S-Corps
      • Rental Losses with an S-Corp
      • Rentals Owned by an LLC Fallacy
      • W-2 or 1099-MISC That Is The Question
  • Expat and Expatriate KB

    • Expat FAQs

      • Are there any downsides to claiming the foreign earned income exclusion?
      • Are there exceptions to the bona fide residence or physical presence tests?
      • As an ExPat, do I need to file a State tax return?
      • Can I deduct mortgage interest paid on my foreign home?
      • Do I have to pass the same test each year?
      • Does voting through an absentee ballot mess up my bona fide foreign residency?
      • How do fluctuating currency values affect my taxes?
      • How do I handle my foreign rental property?
      • How do I qualify for the foreign earned income exclusion?
      • How do moving expenses affect my exclusion?
      • How do partial years work with the foreign earned income exclusion?
      • How do tax treaties affect my ExPat situation?
      • How does the foreign housing exclusion or deduction work?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If I don't qualify for the housing deduction, can I still deduct expenses?
      • May I still make contributions to my IRA as an ExPat?
      • What amount can I deduct for foreign earned income exclusion?
      • What happens if my host country has a form of social security?
      • What is a tax home or abode, and how do they relate to each other?
      • What is considered foreign earned income?
      • What is foreign earned income exclusion?
      • What is the bona fide residence test?
      • What is the difference between foreign tax credit and deduction?
      • What is the physical presence test?
  • Rental Property KB

    • Rentals FAQs

      • Can I claim my residence as a rental, sell it for a loss and deduct the loss?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Can I deduct the taxes associated with public improvements?
      • Can I rent out half a duplex or a room in my house?
      • Do I need receipts for my rental expenses?
      • Do rental properties offer good tax sheltering?
      • How are repairs and improvements different?
      • How do I handle my foreign rental property?
      • How do passive loss limitations affect me?
      • I purchased a rental property last year. What closing costs can I deduct?
      • If I don't have any rental income can I still claim a loss?
      • If I move back into my rental, how does that work?
      • If my employer provides a cell phone, is that income?
      • Is depreciating my rental a good thing?
      • My rental sale was a huge loss. What can I do?
      • Rentals Owned by an LLC Fallacy
      • What are tax issues with an LLC owning a rental property?
      • What are the exceptions to rental activities?
      • What are the rules on a home office deduction?
      • What is active participation versus material participation?
      • What is considered rental income?
      • What rental property expenses can I deduct?
    • Real Estate Pros

      • Are rental activities always passive activities?
      • Are there downsides to the real estate professional designation?
      • Are there specific material participation tests for real estate professionals?
      • Do I need to group my rental activities together?
      • How do I record the hours spent as a real estate professional?
      • If I meet the 750-hour test, do I also meet the 500-hour material participation test?
      • What activities count and don't count?
      • What are some of the IRS tricks to deny my real estate professional designation?
      • What are some of the tax court cases for real estate professionals?
      • What are the general tests for material participation?
      • What is active participation versus material participation?
      • What is the definition of real estate professional?
      • Why designate myself as a real estate professional?
  • Other Tax Information KB

    • Audits

      • Can I ignore an IRS notice or claim I never received it?
      • How can I pay my taxes or my notice of deficiency?
      • How can I prepare for my face to face or interview field audit?
      • How do I appeal the collections of unpaid taxes?
      • How does a joint return get handled during an audit?
      • How does bankruptcy affect my unpaid taxes?
      • How much is interest and penalty on taxes owed?
      • How should I respond to an IRS notice or letter?
      • What are my chances of being audited?
      • What are some of the types of IRS notices and letters?
      • What can the IRS do if I don't pay my taxes- what is the collections process?
      • What causes or triggers an IRS audit?
      • What if I cannot pay my taxes?
      • What IRS publications deal with audits?
      • What is the appeals process?
      • What is the period of limitations for an audit?
      • What types of audits could I face?
      • Who can be with me at my IRS audit or conference?
    • Charitable Contributions

      • Are there ways to earmark money for an individual?
      • Do I need receipts for my donations?
      • Does deducting charitable contributions cause an audit?
      • How do I determine the value of my donation?
      • What are some of the donations I can deduct?
      • What are some other charitable deductions?
      • What are the limits of my donations?
      • Who qualifies as a charity?
      • Why give to charities?
    • Education, Tuition Deductions

      • Are Educational Savings Accounts Worth It
      • Are There Tax Breaks for Going to College
      • Are There Tax Savings When My Employer Pays for My Education
      • Can I deduct the cost of sports, games or hobbies while in college?
      • IRAs and Savings Bonds To Help With Higher Education Costs
      • What College Expenses Can I Deduct From My Income
      • What constitutes a full-time student for tax purposes?
    • Homes and Real Estate FAQs

      • Can I deduct the loss on my primary residence?
      • Can I deduct the taxes associated with public improvements?
      • Can I exclude the gain on my home sale?
      • How does a Federal Disaster affect my casualty loss?
      • My home was destroyed- what deduction can I take? How do casualty losses work?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What are the rules on a home office deduction?
      • What is Cancellation of Debt? Is it taxable income?
    • Medical, Health Insurance

      • What are qualified medical expenses?
      • Why can't I deduct health insurance premiums?
    • Mortgages, Bad Debts

      • Can I deduct a bad debt on my tax return?
      • Can I deduct the loss on my primary residence?
      • Is cancellation of debt always taxable?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What is Cancellation of Debt? Is it taxable income?
    • Recordkeeping

      • Are there specific records I need to keep?
      • Do I need receipts for my expenses?
      • How does proper recordkeeping affect my audit results?
      • How long do I have to keep records?
      • How should I maintain my tax records?
      • What are the requirements for mileage records?
      • Why should I keep tax records?
    • General Tax Questions

      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • If my employer provides a cell phone, is that income?
      • Tax Brackets Misconceptions- Should I earn more money?
      • What is the marriage penalty and how does it affect our tax returns?
  • Small Business KB

    • Small Biz FAQs

      • Hobby Versus Business

        • 3 out of 5 Test
        • Hobby Versus Business Testing
        • Philosophy of Business Losses
        • Private Track Coach Deducts Business Losses for Eight Years, Court Says OK
        • WCG (formerly Watson CPA Group) Philosophy on Hobby Losses
      • Independent Contractors

        • Behavioral Control
        • Colorado's Criteria for Contractor Status
        • Employee or Independent Contractor
        • Employee or Independent Contractor Status
        • Financial Control
        • IRS Determination, Form SS-8
        • Misclassified Workers Can File Social Security Tax Form
        • Salespeople As Contractors
        • Sample Response to CO Unemployment Claim
        • Statutory Employee and NonEmployees
        • Tax Court's Checklist
        • Type of Relationship
      • LLC and S-Corps (superseded)

        • As a one-person show, should I still form an LLC? An S-Corp?
        • Automobiles and LLCs, S Corps (superseded)
        • Can I call my 1099 other income which avoids employment taxes?
        • Determining the S-Corp Payroll Amount
        • Estimated Tax Payments, Withholdings Issues for an S-Corp
        • How do I convert my LLC to an S-Corp?
        • How does an LLC or S-Corp's income affect my taxes?
        • If the S-Corp taxation is what I ultimately want, should I form an LLC or C-Corp?
        • Is there a way to avoid Self-Employment tax?
        • Should I convert my LLC to an S-Corp (Sub-S Election)?
        • Should I form an LLC with my spouse?
        • The S-Corp Grind, Operational Hassles
        • The Zero Dollar Paycheck
        • What are the operational hassles of an S-Corp LLC?
        • What is an Accountable Plan?
        • The Money Trail for S-Corp Elections
        • 185 Reasons NOT to S-Corp, Downsides to S-Corp Election
      • Can I call my 1099 other income which avoids employment taxes?
      • Can I deduct country club dues as a business expense?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Health Care Expenses, Premiums, HRAs, HSAs - Section 105
      • Hobby Versus Business Article
      • How can I avoid or reduce Self-Employment (SE) taxes?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If my employer provides a cell phone, is that income?
      • LLCs and S-Corps
      • Retirement Planning within an S-Corp
      • S-Corp Hard Money Facts, Net Savings
      • Turn Your Vacation Into a Tax Write Off
      • What are tax issues with an LLC owning a rental property?
      • What are the rules on a home office deduction?
      • What business or corporate expenses can I deduct?
      • What do I do with a 1099-K?
      • What is the difference between a hobby and a business?
      • What is the difference between an LLC, S-Corp and a C-Corp?
      • Why can't I deduct health insurance premiums?
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Processing S Corp Payroll

Created OnOctober 10, 2021
UpdatedOctober 21, 2021
byJason Watson, CPA
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By Jason Watson, CPA
Posted Sunday, October 10, 2021

In this section we will discuss establishing the salary amount, payroll cadence, tax planning and withholdings, and adjustments.

Establishing the Salary Amount

We’ve discussed the theory behind calculating a reasonable S Corp shareholder salary in another chapter. You are also aware of the benefits of an S corporation such as K-1 income being taxed at the income tax level only, and not subjected to payroll taxes such as Social Security, Medicare, unemployment or disability taxes. This is one of the reasons you are using an S Corp election (probably the only reason).

As the theory of S Corp salary suggests, the amount to pay as a reasonable wage is dependent on you but also on the health of the business. Here’s what we do at WCG-

  • During the initial onboarding, we review your qualifications and projected net ordinary business income after expenses and deductions for the year. From that information, we determine a reasonable salary amount. Not too high. Not too low. Goldilocks style.
  • Next, we adjust the income tax withholdings to account for your overall income tax obligations as a household. Our goal is to land on tax neutrality which we define as a $1,000 refund from the IRS and a $500 refund from the state. This requires tax planning, which is only done in May, June, July, November and December (the other months are shockingly filled with tax return preparation). As such, if we fire up payroll in Q1 or Q3, then we SWAG it (yes, accountants can SWAG things) and mark our calendars to tighten up the income tax withholdings once the tax plan is done (see Tax Planning below).
  • We establish a cash needs number for processing payroll. A general rule of thumb is about 10% over the recommended salary for employer related payroll taxes. For example, let’s say a reasonable shareholder salary is $60,000 or $5,000 per month. The cash that is necessary to be in your business banking account each month is about $5,500 ($5,000 + 10%).
  • WCG uses ADP for payroll processing, and our platform is called “Run Wholesale.” Not sure why. But the clever thing here is that we get to say your payroll is on “Run and Done” similar to “Set it and forget it.” Keep in mind future tax planning and adjustments, which we will discuss in a bit. We know, it’s super riveting and you just can’t wait.

Another consideration is a late S corporation election with equally tardy payroll events. Let’s say it is October and we want go back to January 1 with a late S Corp election, and we also establish a reasonable shareholder salary of $60,000. There are only 3 months remaining, so each month will be $20,000 in salary amounts to account for the entire year. There might be some tinkering with the cash needs if you’ve already paid a bunch of estimated tax payments for the year.

Payroll Cadence

WCG recommends processing shareholder payroll for your S corporation monthly unless you already have a team on a payroll cadence such as bi-weekly or semi-monthly. Some accountants will simply run S Corp payroll once a year in December. In our opinion, this is bad for three big reasons-

  • This contradicts your intention to establish a salary based on your credentials, work patterns, complexity of the business, etc. All those theoretical things the IRS and Tax Court use to determine a reasonable salary (we discussed separately in another chapter). To the best of your ability and circumstance, salaries should be forward-looking or contemporaneous, at least have the appearance.
  • Running payroll once a year is a horrible budgeting tool. By processing payroll monthly, we ease you into your tax obligations throughout the year. We also tie estimated tax payments into payroll which further helps you budget (more on that when we get into the nuts and bolts examples later in this chapter). A $60,000 one-time salary event in December could easily require over $25,000 in cash for tax withholdings. We are all humans first, and budgeters second. Spreading the pain throughout the year helps your cash flow budget and subsequent decision-making (should you buy a new car or a used car).
  • Some states will close payroll accounts if you file more than two quarterly payroll filings in a row without salaries or wages. Processing shareholder payroll monthly avoids this issue.

Tax Planning and Withholdings

Estimated tax payments change as well when you have an S Corp, especially the first year. Generally speaking, you are required to pay at least 100% of your prior year tax liability or 90% of your current year tax liability whichever is lower. If you earn over $150,000, you must pay 110% of your current year tax liability. How do you keep that straight?

Here is some more WCG elegance (yeah, we’re bragging a bit)- we calculate and pay your quarterly estimated tax payments through your payroll withholdings. No more writing separate checks or using online payment portals, and tracking due dates. We do this by manually entering your federal and state withholdings accordingly to reflect the tax liability for your W-2 income and your K-1 income, plus other household sources. Beauty!

For example, let’s say you have a net ordinary business income after expenses and deductions before shareholder salaries of $150,000 and a reasonable salary of $60,000. From there, we look at all household income sources such as your spouse’s income and withholdings, rental income, pension income and anything else that is material to your tax world.

Then we create a mock tax return (the tax plan). That’s right! We extrapolate all this data, pump it into a tax return and determine your tax obligations. We do this periodically throughout the year. Nothing is as accurate as a mock tax return. Yes, you can use Excel or other online estimators, but a tax return is the best tool.

Then we crunch some more numbers. Here is a summary from our internal work paper with some assumptions-

Taxable Income 184,718
Income Tax Calculation 33,606
Less Other Withholding Sources -8,000
Household Tax Deficit 25,606
Less W-2 From S Corp -26,500
Less Estimated Tax Payments 0
April Tax Obligation (Federal) -874

What the heck are we showing you here? The taxable income is making some assumptions such as spousal income, itemized deductions, exemptions, etc. The $184,718 is just a number. Please accept as is.

The tax related to this income is $33,606 according to the mock tax return and your spouse has withheld $8,000 on his or her W-2. The resulting house tax deficit in this example is $25,606. If we simply entered $60,000 into the payroll system and let payroll tables figure out the withholdings it might come up with $7,000ish. This would be a tax surprise in April since you would owe $18,000ish. Yuck. Bad news is OK. Surprises are bad.

This is because the payroll computer does not know about your K-1 income. The net ordinary business income after expenses and deductions from your S Corp tax return. Generally, when you have multiple income sources, especially ones without a withholding component such as K-1’s and rentals, relying on payroll tables to determine withholdings is woefully inaccurate.

You could also have income disparity. For example, let’s say you earn $150,000 and your spouse earns $30,000. When your spouse’s employer computes tax withholdings, the payroll system does not understand that the household income is $180,000. It can only make basic assumptions. In this disparity, even if the $30,000 spouse claims 0 exemptions on a W-4 (max withholdings), the taxes withheld will not be enough when combined with the $150,000.

Our tax planning and income tax withholdings adjustments fixes this.

To summarize, we compute your household tax liability and subtract external withholding sources to determine the amount of tax to be withheld from your S Corp payroll. No more estimated payments (usually). No more underpayment penalties. This is a nice way of reducing some chores in your world.

Payroll Adjustments

There are various payroll adjustments throughout the year. Let’s say you onboard with WCG in February. We are going to do a quickie calculation of the reasonable salary and income tax withholdings to get things launched. However, in June or July we are going to dig into the details, prepare the tax plan and make an adjustment to your payroll processing.

Another common scenario is where you might not be able to accurately predict your business activity for the year. For example, a real estate agent in March has no idea how much he or she will earn for the year. But in October and November, there is enough history to predict the future. What we do with this is use a small salary such as $1,500 per month to check the box, and then make adjustments in July and certainly in November.

Yet another situation is the S Corp owner who is experiencing rocket growth. If we use the previous year as a proxy for the first half of the next year (which is common), a large adjustment must be made in July to account for the growth. The adjustment is not necessarily about salary as it is about tax planning and income tax withholdings.

A common question is “Does it look bad if my salary changes throughout the year?” The answer is simply No. Think of sales and commissions or bonuses. Many professionals and other employees see varying incomes throughout the year. Also, the IRS looks at things in aggregate, and assume that income and taxes withheld were evenly paid throughout the year. Big swings in income from year to year is certainly a trigger for audits, but mid-year salary adjustments is not that.

Estimated Tax Payments

Our goal is to increase income tax withholdings to account for your overall household tax obligations. However, there are times when this doesn’t work well, and separate estimated tax payments are necessary. There are two primary reasons for this.

First, you have a low salary relative to your solo 401k plan contribution. For example, a reasonable shareholder salary of $30,000 is determined. You are 52 years old, and want to defer $19,500 (for the 2021 tax year) plus catch-up of $6,500 for a total of $26,000. That leaves $3,000 for Social Security, Medicare and income tax withholdings. Never going to happen, so a separate estimated tax payment will be needed.

The other reason is similar to the above; your shareholder salary is low compared to your K-1 (which is net ordinary business income after expenses and deductions). For example, your W-2 is $100,000 but your K-1 is $500,000. Yes, you have employees so you are not being limited on the Section 199A qualified business income deduction. No, you don’t have enough “room” on your paycheck to increase income tax withholdings to cover the taxes associated with $600,000 in gross income. Even if your effective tax rate with the IRS and the state was only 20%, which is low, it still doesn’t work with a $100,000 W-2.

Unemployment and Workers Compensation

We addressed these issues in Chapter 4. Please review. Here is a summary of the topics-

  • FUTA and SUTA- unemployment tax. Unavoidable. You might be able to opt out, and as the Minnesota example in an earlier chapter illustrates, there is a tax savings.
  • SDI- state disability insurance. Might be able to opt out for single-owner corporate officers such as California and New York.
  • Workers Compensation Insurance- has nothing to do with unemployment or state disability insurance, and is not interchangeable with those terms. This is purely insurance coverage for on the job injuries and is provided by private insurance such as State Farm, All State, Farmers, etc. Ask your local insurance agent if you can opt out. Typically you can since you don’t plan no suing yourself for a paper cut or a rogue paperclip stabbing.

Salary First, Distributions and Loans Second

We wanted to throw this at you as well. Shareholders must be paid a salary before any shareholder distributions are paid out or loans are advanced to shareholders. This requirement is a technicality. You can take a shareholder distribution as an S Corp owner prior to paying a salary to yourself throughout the year. At the end of the year, however, you must have W-2 income if you received shareholder distributions.

If the business cannot afford to pay salaries, it is not necessarily required to do so. There is some gray area involving large depreciation expenses and other non-cash reductions in business income. So, if you have a pile of cash but experience a loss due to large depreciation, for example, you might still be required to pay salaries. If you believe your business won’t be profitable, then we suggest deferring the S Corp election to another tax year. Remember there are provisions allowing a late S Corp election beyond the customary 75-day limitation- take advantage of this option by delaying your election if you are unsure.

Jason Watson, CPA, is a Senior Partner of WCG, Inc., a boutique yet progressive tax and
consultation firm located in Colorado and South Dakota serving clients worldwide.


Jason Watson CPA LinkedIn     Jason Watson CPA Email

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