As you are probably aware an S corporation is usually not subject to tax at the corporate level. Instead, the corporation's income and deductions are passed through to the shareholders. This income is not subject to employment taxes including social security taxes. In most cases the shareholders will distribute the profit of the corporation to themselves. Thus, by using an S corporation, employment taxes can be avoided.
The IRS requires that the corporation pay its officers/shareholders reasonable compensation for their services to the S corporation. This compensation is subject to employment taxes. There is no simple formula regarding what is reasonable compensation. Presumably, reasonable compensation would be the amount that unrelated employers would pay for comparable services under like circumstances. If the corporation does not pay reasonable compensation, the IRS may treat some or all of the profit distributions as wages and will impose employment taxes on these deemed wages. Additionally, the IRS can impose penalties and interest for not paying in the employment taxes along with any income tax withholding that would have been required if wages had been paid.
In the last few years the IRS has performed more audits of the wages paid by S corporations to their officers/shareholders. It is area they perceive as capable of generating tax revenue.
As such we want to be sure you understand the risks of not paying reasonable compensation from your corporation which include additional taxes, interest, and penalties along with the cost of being audited in terms of time and representation fees.
Corporations that pay more than $2,500 per quarter in Federal employment taxes must remit all employment taxes electronically. To do this, the corporation must be registered with the Electronic Federal Tax payment System ("EFTS") program. You can register your corporation by going to www.EFTPS.gov. If you reside in California, the corporation must be registered with the California Employment Development Dept. ("EDD") You can register by completing form DE 1 which is available on the EDD's website. State employment taxes are paid to this agency. Other states have agencies to pay in employment taxes.
If your corporation has not been paying wages, you will need the information on how to compute the employment taxes and income tax to withhold, deadlines for making deposits, as well as the filing requirements for payroll tax returns.
Many S corporations are paying health insurance for its shareholders or are reimbursing them for premiums paid. In order for there to be an allowable deduction for the health insurance, the amount of health insurance must be included in the gross wages of the shareholders. While the shareholders' gross wages increases, the profit of the S corporation decreases by the same amount because wages paid to by the corporation are deductible. Since the profit of the S corporation flows through to the shareholders' tax returns, the shareholders are in the same position taxwise. However, the shareholders are entitled to deduct the cost of the insurance on their personal tax returns thereby receiving tax benefit.
Fortunately, the cost of the health insurance is not subject to Federal employment taxes.
You must be sure that the cost of health insurance is included on the W-2s of the shareholders. The cost can be added to the 4th quarter wages. If you use a payroll service, be sure to inform them of the amount of the health insurance that is being added to the wages so the 4th quarter payroll reports and the W-2s are correct.
