When you have decided to open up a business, it’s essential to take the time to establish a reasonable salary for your staff. If you don’t pay a fair wage, you’ll expose yourself to serious trouble from the IRS.
FUTA and FICA taxes
If you own an S corporation, you will have to pay federal unemployment taxes, also known as FUTA, on your employees’ wages. It’s essential to understand what is an S corporation and how these taxes work because failure to pay them can result in fines, interest, and penalties.
First, you should be aware of the FUTA tax rate. This is the tax rate on the first $7,000 of wages each employee pays in the year. In 2020, the tax rate will remain the same. However, if you contribute to state unemployment programs, your FUTA tax rate can be reduced by as much as 5.4%.
Employers are subject to the FUTA payroll tax, which is used to pay for unemployment insurance programs across the country. You can report your FUTA tax obligations on the IRS Form 940.
The IRS considers your Form 940 filed on time when it’s received in full, appropriately addressed, and postmarked by the end of the month. If your form is late, you will be assessed a penalty. Your penalties vary according to your business’s turnover.
For most businesses, FUTA taxes are paid quarterly. Companies can use the Electronic Federal Tax Payment System to deposit their FUTA tax electronically. They can also mail their Form 940.
FUTA taxes are calculated using a general test. Generally, an employer must withhold 6% of the first $7,000 of each employee’s wages. A separate test applies to household workers.
Employers must report their FUTA tax obligation on the IRS Form 940 annually. This form is required by law. Some states have additional rules and regulations, which can complicate the process.
A reliable system for paying your tax liabilities is essential for any business. Make sure to take advantage of free resources on the IRS website to get the most up-to-date information.
Health insurance and pension are not taxed.
Health insurance and pension are not taxed for employee shareholders in a single-person S corporation. However, the IRS is concerned about owner compensation. If the company does not provide reasonable compensation to its owners, it is subject to an IRS audit.
The Internal Revenue Service has issued notices in the past regarding the treatment of health care fringe benefits. These notices have provided guidance for calculating federal Health Coverage Tax Credits and above-the-line deductions for 2 percent shareholder-employees.
The cost of health insurance has a disproportionate impact on money wages below the taxable maximum. It is estimated that increasing health care costs reduce the fraction of money wages that are below the taxable maximum by between five and six percent.
One way S corporations can avoid taxing health insurance, and pension is to pay for their own premiums. This can be accomplished through an employer payment plan. Notice 2015-17 explains this arrangement.
S corporations may also report health care fringe benefits in their shareholder W-2. The amount of such reimbursement is also included in the shareholder’s gross income. A qualified employee discount is also excluded from income. Eligible employee discounts must be available on a non-discriminatory basis.
S corporations may also report compensation to their shareholder-employees through Form 1040-ES. Shareholder employees will report payroll taxes withheld from their salaries. They will also file quarterly taxes and report income taxes on their earnings.
S corporation shareholders will report health insurance premiums as taxable compensation in their W-2. However, they may be eligible for an above-the-line deduction if they meet specific requirements. IRC Section 162 provides this option.
For example, the shareholder can report the amount of a medical insurance premium as an above-the-line deduction. Other healthcare benefits must also be noted on the W-2.
IRS will call foul play if you don’t pay a reasonable salary
The IRS will call foul play on any S Corp owner who does not pay a reasonable salary. There are many factors the IRS considers before determining what a good salary is, such as experience, day-to-day responsibilities, and the industry.
One of the best ways to determine a reasonable salary is to find the average salary for a similar job at the Bureau of Labor Statistics. You can also consult the IRS’s annual reports for the average wages in various industries.
The 60/40 rule is one of the more common ways to set up a salary. This means that 60% of your gross revenue is paid as a salary, while 40% is delivered as a profit distribution. However, this is not a guarantee that your salary will pass muster.
A 50/50 rule is another way to establish a reasonable salary. If you earn $50,000 a year, you will pay yourself $30,000 in compensation and $25,000 in profit distributions. Alternatively, you could make a $100,000 income and pay yourself an additional $10,000 salary.
In addition to paying yourself a “reasonable” salary, you should keep records of how you spend your employees. Those records will come in handy if the IRS ever conducts an audit.
For example, if you have a single employee, you typically pay them in small payments throughout the year. Pay them a sizeable year-end bonus at the end of the year.
An S Corp owner can pay himself a salary once a year, quarterly, or annually. Choosing which payment method to use depends on your company’s finances.
As with any business, the IRS will look at several factors before determining a reasonable salary. If you need more clarification, you should seek the advice of a CPA.