Colorado Business CPA, LLC
May 22, 2017
Your S-corporation Guide from A to Z!
Two main reasons people choose to do business as an S-corporation.
Running a business as an S-corporation provides two main advantages- tax savings and decreased audit risk. Net income from S-corporation is not subject to self-employment or payroll taxes, which is 15.3%. This is why it can be a great tax savings tool for small business owners. However, we will be discussing payroll requirements for a reasonable salary later.
Another significant reason for doing business as an S-corporation is the fact that IRS audit risk decreases about 10 times when you operate your business, especially with the losses as an S-corporation or a partnership. To minimize your chances for audit risk, consider moving your business activities from a Schedule C to any other type of entity.
Best business activities for S-corporation
S-corporation is ideal for best for small businesses whose owners are 100 % actively involved in their business. This type of entity is especially beneficial when you have only one owner (or spouses) operating your active business. Due to limitations on shareholder’s distributions, it is recommended to consult with your tax accountant regarding your case. Being actively involved in the business means that the income is considered earned income which is a great tax deduction strategy. Holding real estate investments in an S-corporation is not the best option. Partnerships would be the best option for that.
All shareholders of an S-corporation must be US residents or US citizens.
How to become an S-corporation
In order for your business to be taxed as an S-corporation, you need to file form 2553 by March 15th of the year when you want your business to be taxed as an S-corporation. You also have 2.5 months since the inception of the business to file this form timely.
If you missed the timely filing deadline, there is a chance to file a late S-election, by choosing and writing on the top of the form Filing Pursuant Revenue Ruling 2013-30. You also need to have a reasonable cause why you are filling late and failed to file your tax return timely.
For example, let’s say you open your business in September 15th 2017. You have until November 30th to file a timely S-election form 2553 to select your business to be taxed as an S-corporation effective September 15th 2017. You can still file a late S-election form until March 15th 2018 with the Revenue Ruling Option 2013-30 for your business to be taxed as an S-corporation effective September 15th 2017.
Requirements for payroll.
As we discussed before, when your S-corporation makes money and you take shareholder’s distributions, you need to have a payroll for yourself by filing quarterly payroll reports and submitting payroll taxes. Net income from S-corporation and from your shareholder’s distributions are not subject to self-employment tax. Therefore, IRS requires you to pay payroll taxes via a reasonable salary, usually about 50% of your net income. So, half of your S-Corporation income can be distributed to you via distributions without payroll tax, but half should be distributed to you via shareholder’s/ officers compensation with payroll taxes paid on that amount. This is how you can stay in compliance with IRS regarding compensation.
I guess the question you might ask- how much is reasonable in terms of compensation. Clearly, you don’t want to overpay yourself in compensation as all of that compensation carries additional payroll taxes. However, you don’t want to underpay yourself either. Underpaying yourself raises a red flag to the IRS audit department and ultimately leads to the IRS reclassifying your distributions to compensation and imposing taxes. This is why we always suggest to have a reasonable salary. What is reasonable salary you might ask? Well, how much do you need to pay for your living expenses every month? If you spouse receives W-2 take her income into consideration. Are both of your incomes from W-2 enough to cover your living expenses? The rule of thumb would be pay yourself at least 40% of your corporate income as salary and take 60% as distributions. Another test would be if your net income is lest say $300,000-$500,000, pay yourself up to the maximum for Social Security Wages and take the rest as distributions. How much is the reasonable salary for the same profession in your field? All of these questions need to be addressed when you choose your level of compensation. Also, talk to your tax professional or contact us for individualized help.
We always suggest to let the payroll process be handled by professional company as it is somewhat confusing and penalties for filing late returns or submitting tax payments are stiff.
Here is the detailed step by step process on how to run payroll in Colorado.
First, you need to apply for payroll IDs- such as wage withholding and Colorado Unemployment. You can do this by going to Colorado Business Express: (https://apps.colorado.gov/apps/jboss/cbe/index.xhtml;jsessionid=BBupWtxemsb3qK+RkQ+iLg__) and click on “Start Your Filing”. Your IDs will be available to you after you answer all questions. You can get them in PDF format at the end of the interview process. Before you do that, make sure your business already has a Federal Employer Identification Number, as all payroll activities are attached to that number, and not your social security. Also, make sure to have your business bank account information handy. Sometimes there are might be glitches in their system, and you will have to submit your payroll form applications via USPS. Just remember this is only a one-time process do don’t feel overwhelmed! Once you have payroll IDs you are all set!
Tip: If you do business in Aurora, Denver, Sheridan, Greenwood Village, you also need to apply for Occupational Privilege tax ID. People who work in these cities, must pay occupational privilege tax.
Workers Compensation Insurance
Once you have applied for payroll ID, Colorado Department of Labor is notified that you have employees. Therefore, the worker’s combination insurance notification form will be mailed to you. When you have employees, you must have worker’s compensation insurance. However, if you have more than 10% ownership in your business, you can excuse yourself from that requirement, by sending filled out and notarized form to the Colorado Department of Labor. You might consider to purchase worker’s compensation insurance, if you don't have it yet, if your work is involved in high risk category. For example, roofers, electricians, and other general constructions people might consider having worker’s compensation insurance for themselves, in case they get hurt at work.
Monthly Payroll Process
Your accountant might recommend you a specific amount to allocate and run as payroll for yourself every month. This amount can be determined by how much you need to pay yourself to cover your living expenses as well as to make sure your distributions (the money you take quarterly from your business) do not exceed 60%. It is important to stay in compliance with IRS to avoid audit payroll issues and reclassification of your distributions to payroll.
You must pay yourself monthly (perhaps the company runs the payroll for you or you may contact us to do it for you). The money will be directly deposited to your bank account just like if you had another job. Your Federal Income Tax withholding, yours and employee’s portion of your FICA (Social Security and Medicare tax totaling to 7.65%) will be withheld and submitted to IRS along with your employer matching FICA taxes of 7.65% before the 15th of the next month.
Your State Income Taxes will be withheld every paycheck and most likely submitted for taxes every quarter.
For your Colorado Unemployment tax - the rate of the tax will depend on your category of business. It varies from 2.11% to 10%. The good news it is taxed on $12,500 in 2017 max per employee per year. This tax is paid quarterly when Colorado Unemployment tax return is submitted. If you work with payroll companies, they file these reports electronically. It is not unusual for you to receive a red form from Colorado Department of Labor even if already filed.
Some cities require an additional tax known as Occupational Privileged Tax (OPT). Check with your tax advisor to see if your business is within one of these cities. If so, your OPT reports and taxes are also done quarterly, unless you are required to file and pay these taxed monthly. For one employee it is quarterly.
Quarterly requirements for S-corporations
You must file quarterly payroll forms with IRS, CO Department of Labor and CO Unemployment as well as City Occupational Privilege Tax.
Quarterly forms such as Form 941, CO State Unemployment Form UITR-1 and City tax (Aurora, Denver etc.).
Filing quarterly payroll forms provides reconciliation for the taxes paid and reported.
Some forms might be sent to you, so juts send them to your payroll processing company.
Annual requirements for S-corporations
Besides filing quarterly payroll forms and submitting payroll taxes, S-corporation need to file annual form 1120S. This form reports all your business income and expenses for the year. The tax filing deadline is March 15th or September 15th provided form 7004 (extension was filed).
Failure to file annual reports or filing them late, results in $195 penalty per month per shareholder. Only first time violations can be waived. It is very difficult to waive late filing penalties for S-corporations unless you have very valid reasonable cause.
We recommend to fill out your form in detail, disclosing the balance sheet of your company, even if you are not required to do so by IRS. This helps to reconcile retained earnings and to make sure balance sheet account is in agreement with your reports in your accounting system.
Since S-Corporation is indeed the business, we recommend to use accounting software to help keep track of your income and expenses as well as your assets and liabilities throughout the year. You can utilize software such as QuickBooks Online (QBO), any desktop version of QuickBooks (QB) or any other software available. Make sure you have a business account that you use regularly for all your income. These should always be deposited at that account and use that account to pay all your business expenses as well.
Reporting your health insurance on your W-2
Many business owners ask us how to deduct their health insurance. If you don’t have a group health insurance policy and only one personal account that deducts health insurance, your premiums will be added to your shareholder’s compensation subject to income taxes for Federal and State Income Taxes. We have a video on our YouTube channel - ColoradoBusinessCPA- to gain additional understanding on how this works. (https://www.youtube.com/watch?v=5T83OjaQOW0)
When you report your wages with health insurance premiums as compensation (which is not subject to FICA - Medicare and Social Security Tax), it decreases your income for S-corporation. Then your health insurance premiums will be dedicated as self-employed health insurance in adjusted to gross income section of your individual income tax form 1040.
By proper recording your health insurance on your forms will provide you with higher tax deduction as your premiums will not be reported on Schedule A subject to 10% AGI limitation and basically 90% of the time will have no tax benefits.
Dissolution of an S-corporation
When you no longer wish to operate your company as an S-corporation, you can file a final report form 1120S with final mark on it. Make sure your accountant closes the company books, accrues all outstanding expenses and distributes the rest of the assets to you. Based on the IRS rules, fixed assets are distributed to the shareholder at the fair market value. Therefore, it is a possibility to have gain on disposition of assets if they were depreciated using section 179 deduction.
You also need to file all final payroll forms, make all outstanding payroll deposits and file articles of dissolution with Colorado Secretary of State. Make sure to check with your tax professional to ensure the dissolution is done well.