I have operated a pet-sitting business as an S-corp for the past 1 1/2 years and have never paid myself a salary. During tax year 2004, our income was only $12,000, but in 2005 we netted $35,000. Now I worry that I should have been paying myself a salary and paying payroll taxes. My husband works for me part-time, but I haven't paid him either. Am I going to be in trouble with the IRS?
-- L.G., Coral Gables, Fla.
It's not uncommon for startup entrepreneurs to refrain from taking a salary while they're getting their companies off the ground. However, once your business becomes profitable, both the IRS and your state tax board expect you to pay yourself a salary if you're working in the company.
CPA Gregg R. Wind of Los Angeles-based Wind Bremer Hockenberg, says that tax authorities have recently become more aggressive about requiring S-corporation shareholders to take reasonable salaries. "Published reports have stated that a fair number of small S-corporations, primarily those with gross receipts of less than $100,000, are not reporting any wages paid to employees," Wind says.
Many of them are believed to be taking funds out of the company in the form of "corporate distributions" instead of salaries. In August, 2003, the IRS advised tax professionals and small business owners about the need to understand the law regarding corporate officers who perform services.
A REGULAR PAYCHECK. Why are the tax agencies concerned about this practice? As the owner of an S-corp, you're running a "pass-through" entity and paying state and federal income tax on company profits (even if you do not pay yourself a salary) because you must report the company's revenues on your income tax return. However, by not paying yourself or other employees, you are escaping 15.3% in payroll taxes.
"This amount represents the employee's 7.65% Social Security and Medicare tax, plus the employer's 7.65% Social Security and Medicare tax," says Ted Hilliard, managing consultant of Oakland, (Calif.)-based , Hilliard Management Group. "If you pay yourself a salary, you and the company pay Social Security, state employee taxes, and state and federal employer taxes, such as unemployment, on that salary," he says.
Navin Sethi, a CPA and tax manager in the Walnut Creek (Calif.) accounting office of Rothstein Kass, advises that you determine reasonable salaries for yourself and your husband, and then pay yourselves regularly.
"Several factors [influence] what is a reasonable salary, such as the profitability of the company, the shareholders' background and experience, the compensation paid to others in similar companies locally, and the time spent performing the service. Ask yourself: 'What would I have to pay to hire someone to do the work I perform?'" Sethi advises.
PAYROLL EXPERTS. If your 2005 returns have not yet been filed you can still do this now, although it's likely you may be charged penalties and interest on the late deposit of payroll taxes. You also still have time to amend your 2004 S-corporation returns, but again, you should be prepared to pay penalty and interest charges as well as amend your individual income tax returns for that year, Hilliard says.
He advises that, rather than try to handle payroll yourself, you use a payroll service, send in the appropriate forms, and make your tax deposits on time. "There are several affordable services that can assist you in this area," he notes.
You should also be working closely with an accountant who is knowledgeable about small business finances and tax matters and can advise you on crucial issues like salaries. Meet with this person late in the calendar year to go over the company's performance and determine the optimal amount of salary that you can pay yourself to minimize your tax liability as well as maximize your tax shelters.
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