Running an S Corporation comes with many benefits, including tax savings and limited liability. However, one area that can quickly become a challenge is payroll taxes. Missteps in payroll tax compliance can result in IRS penalties, audits, and unnecessary financial stress. To keep your S Corporation in good standing and avoid costly mistakes, here are key payroll tax pitfalls to watch out for and how to navigate them.
1. Paying Yourself a Reasonable Salary
One of the biggest payroll tax mistakes S Corporation owners make is failing to pay themselves a reasonable salary. The IRS requires that S Corporation owners who perform work for the business pay themselves a fair salary before taking distributions.
How to Avoid This Mistake:
- Research industry salary standards for your role and experience level.
- Ensure that your salary is comparable to what an employee in a similar role would earn.
- Keep documentation to justify your salary amount in case of an audit.
2. Misclassifying Workers as Independent Contractors
Many S Corporations try to avoid payroll taxes by classifying workers as independent contractors instead of employees. However, misclassification can lead to penalties and back taxes if the IRS determines that these workers should be treated as employees.
How to Avoid This Mistake:
- Use IRS guidelines (such as the degree of control over work) to classify workers correctly.
- Issue Form W-2 for employees and Form 1099-NEC for independent contractors.
- When in doubt, consult a tax professional to determine the correct classification.
3. Failing to Pay Payroll Taxes on Time
S Corporations must withhold and pay payroll taxes (Social Security, Medicare, and federal income tax withholding) on time. Late payments can lead to significant penalties and interest charges from the IRS.
How to Avoid This Mistake:
- Set up automatic payments for payroll taxes through the Electronic Federal Tax Payment System (EFTPS).
- Work with a payroll service provider to ensure compliance.
- Keep a tax calendar to track due dates for payroll tax deposits and filings.
4. Taking Excessive Shareholder Distributions
If an S Corporation owner takes large distributions while reporting little to no salary, the IRS may reclassify those distributions as wages, triggering payroll tax liabilities and penalties.
How to Avoid This Mistake:
- Pay yourself a reasonable salary before taking distributions.
- Keep financial records that clearly separate salaries from distributions.
- Work with an accountant to ensure that your compensation structure is compliant.
5. Not Filing Payroll Tax Returns Correctly
S Corporations must file various payroll tax forms, including:
- Form 941 – Quarterly payroll tax returns
- Form 940 – Annual Federal Unemployment Tax Act (FUTA) return
- W-2 Forms – Issued to employees at year-end
- Form 1099-NEC – Issued to independent contractors
How to Avoid This Mistake:
- Use payroll software or hire a payroll service to automate tax filings.
- Double-check forms for accuracy before submission.
- File all required forms on time to avoid penalties.
6. Ignoring State Payroll Tax Requirements
While federal payroll taxes get most of the attention, S Corporations must also comply with state payroll tax laws. Requirements vary by state and may include unemployment insurance, disability insurance, and local withholding taxes.
How to Avoid This Mistake:
- Research your state’s payroll tax requirements.
- Register with the appropriate state tax agencies.
- Keep up with state tax deadlines and filing obligations.
7. Not Keeping Payroll Records Properly
The IRS requires businesses to keep payroll tax records for at least four years. Poor record-keeping can make it difficult to defend against audits or correct tax filing mistakes.
How to Avoid This Mistake:
- Maintain records of payroll tax payments, employee wages, and benefits.
- Use cloud-based accounting and payroll software to organize records.
- Ensure that payroll records are easily accessible for future reference.
Payroll Tax Compliance
Payroll tax compliance is critical for S Corporations to avoid IRS scrutiny and financial penalties. By paying yourself a reasonable salary, classifying workers correctly, paying payroll taxes on time, and maintaining proper records, you can steer clear of common payroll tax pitfalls. Consider working with a tax professional or payroll service to ensure your S Corporation remains in compliance and maximizes its tax efficiency.
