What is an S Corporation and how does it impact your payroll?

For small business owners, choosing the right legal structure for your business can feel overwhelming. Among the many options, the S Corporation — or S Corp — often stands out for its tax advantages and operational simplicity.

But what exactly is an S Corporation? And if you own one, what are your payroll responsibilities? In this guide, we’ll break it all down in simple terms, and explain what you need to know. So let’s jump straight in.

What is an S Corporation?

An S Corp is a type of business entity that combines the liability protection of a corporation with the tax benefits of a partnership. Unlike a traditional corporation (C Corp), an S Corp allows profits and losses to "pass through" directly to the owners' personal tax returns, avoiding the double taxation common in C Corps.

The key features of an S Corp include:

1. Pass-through taxation. As mentioned, S Corps avoid federal corporate taxes. Instead, income is passed through to shareholders, who report it on their individual tax returns.

2. Liability protection. Shareholders also have limited liability, meaning personal assets are generally protected from business debts or lawsuits.

3. Ownership rules. An S Corp can have up to 100 shareholders, all of whom must be US citizens or residents.

4. Operational requirements. While simpler than a C Corp, an S Corp still requires bylaws, annual meetings, and record-keeping.

Is an S Corp a private entity?

Yes, an S Corp is a private entity. It is owned by its shareholders and not publicly traded. This makes it an ideal option for small business owners who want to maintain control over their company while benefiting from the tax advantages.

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Do you need to run payroll in an S Corporation?

If you own an S Corp and actively work in the business, the Internal Revenue Service (IRS) requires you to pay yourself a “reasonable” salary. This is to prevent abuse of another IRS law that allows business owners to distribute their profits as dividends, which are not subject to payroll taxes.

This salary is subject to payroll taxes, just like any regular employee.

How to determine a reasonable salary

The IRS doesn’t define reasonable compensation in exact terms, but when assigning yourself a salary, some factors to consider are:

• Industry standards. Research salary ranges for similar roles in your industry. For example, if software engineers in your region earn $90,000 annually, that’s a good benchmark for an owner-employee performing similar tasks.

• Time commitment. The number of hours you work in the business should influence your salary. A full-time owner should receive a salary comparable to a full-time employee in a similar role.

• Company profitability. Your S Corp’s income and financial health will also determine how much you can afford to pay yourself. The salary should be proportional to your business’s revenue and profits.

For example, imagine you own a digital marketing agency and serve as the lead strategist. Based on industry research, the average salary for a marketing strategist in your area is $80,000 annually. Since you work full-time, your reasonable salary would likely align with that figure.

It’s important to note that overpaying or underpaying yourself can raise red flags with the IRS. Underpaying (to minimize payroll taxes) can trigger audits, while overpaying may hurt your business’s cash flow. As a result, it’s crucial to strike the right balance.

How to run payroll in an S Corp

As mentioned, setting up and running payroll in an S Corp is essential for complying with IRS rules. Here’s how to get started:

1. Set up payroll

Before running payroll, there are a few critical steps you need to take to establish a compliant payroll system. You will need to:

• Obtain an Employer Identification Number (EIN): This is required to process payroll and file payroll taxes.

• Choose a payroll system: You can outsource to a trusted payroll provider, or hire in-house payroll specialists.

• Classify yourself correctly: As an owner-employee, you’re both the employer and employee. Ensure your salary reflects this dual role.

Note that choosing whether to hire internally or outsource your payroll is a crucial decision. Outsourcing to a trusted provider — such as Remote Payroll — saves time, reduces costs, minimizes errors, and ensures full compliance with all employment and payroll tax laws.

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2. Process payroll regularly

Once you’ve set up your payroll process and determined your reasonable salary, you must set up a consistent payroll schedule. Treat yourself as a regular employee by:

• Setting pay periods: Choose a bi-weekly, semi-monthly, or monthly payroll schedule that aligns with both your business operations and the legal requirements of your state. See the requirements for your state.

• Calculating payroll taxes: Deduct federal, state, and local taxes, along with Social Security and Medicare contributions (also known as FICA taxes). As an employee, you’ll pay half of the FICA taxes, while the business covers the other half.

• Withholding income taxes: Federal and state income taxes must be withheld from your salary, just like any other employee.

An automated payroll provider like Remote automatically calculates and withholds these amounts for you, ensuring accuracy and compliance.

3. File your payroll taxes

Running payroll isn’t just about paying yourself. It also involves timely filing and remittance of payroll taxes. As an S Corp owner-employee, you must:

• File Quarterly Payroll Tax Returns (Form 941): Report federal income taxes, Social Security, and Medicare taxes withheld from your wages.

• Pay FUTA taxes (Form 940): Federal Unemployment Taxes apply to employee wages, including your own salary. Learn more about FUTA taxes.

• File W-2 forms annually: As an employee, you must issue yourself a W-2 form at the end of each year. Learn more about Form W-2.

Neglecting to file payroll taxes or missing deadlines can result in penalties, interest, and increased scrutiny from the IRS. Again, Remote Payroll automates this process, and ensures that all the correct reporting paperwork has been completed and filed correctly.

4. Understand the difference between dividends and salary

One of the key benefits of an S Corp is that you can distribute a portion of your business’s profits as dividends in addition to your salary — within reason. Dividends aren’t subject to payroll taxes, which can save you money.

However, it’s important to strike the right balance. You must first pay yourself a reasonable salary before distributing profits as dividends. Taking disproportionately low salaries while withdrawing large dividends can lead to IRS audits and penalties.

For instance, if your S Corp generates $150,000 in net profit annually:

• You must pay yourself a reasonable salary of, say, $80,000. This should be justifiable based on the factors described above.

• The remaining $70,000 can be distributed as dividends, free from payroll taxes.

This balance allows you to optimize tax savings while remaining compliant.

How Remote can help

Running payroll can be complex, especially for small business owners juggling multiple responsibilities. To simplify the process, Remote Payroll:

• Calculates salaries and taxes accurately

• Automates tax filings and payments

• Ensures full compliance with frequently-changing federal, state, and local regulations

Learn more about how Remote Payroll can remove all your payroll compliance headaches and ensure a smooth and reliable experience.

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