If you operate your business as an S corporation and pay yourself on a 1099-MISC, then you’re possibly in violation of tax law, which can subject you to substantial tax liabilities and penalties.

The law requires you to pay yourself a salary for the work you do for the corporation. Your salary should be reasonable based upon your position, hours worked, and duties performed. It should also be equivalent to executives or employees in similar businesses. The salary shouldn’t be in the form of distributions or 1099 payments. The payments should be run through payroll to ensure the proper income tax, social security and unemployment taxes are deducted as they are for a non-shareholder employee or a worker in another company. The business can deduct the wages and taxes from income as operating expenses.

You may be tempted to pay yourself as a 1099 recipient, as life seems so much simpler this way – no payroll taxes to deal with, no payroll tax returns to file, and no payroll services fees to pay. However, having your S corporation pay you this way could cost you thousands of dollars in taxes, interest, and penalties! Because this is a violation of tax law, the IRS can reclassify your 1099 payments as W-2 wages and collect the back payroll taxes and interest on the payroll taxes. Penalties for failure to file a Form 941 each quarter, failure to deposit the tax withholdings each quarter and failure to issue a Form W-2 can also be assessed.

There’s no requirement that an S corporation pay out all of its profits to the shareholder as wages. You may be able to apportion the payments between wages and distributions. Distributions are deemed to be a return on the shareholder’s investment. They’re included in a shareholder’s taxable income but aren’t subject to payroll taxes and aren’t considered self-employment income subject to self-employment tax.  Determining this apportionment can be tricky, so contact us for assistance.

For more information, contact Padgett Business Services in Bothell, Washington at (425) 408-1695. We handle your bookkeeping, accounting, tax (personal & business) and payroll needs – so you can focus on what makes you money. Serving Bothell, Lynnwood, Kenmore, Mill Creek and surrounding areas.