Operating your business through an LLC with an S corporation election has many advantages. One of the greatest advantages is the ability to shield a portion of your income from self-employment taxes. Whatever you don’t pay yourself through W-2 payroll can be withdrawn from the business as tax-efficient dividends (aka distributions). Like most things, this is easier said than done. One of the biggest hurdles faced by independent contractors to implement the S corporation strategy is implementing payroll correctly.
When we say “payroll”, what does that mean you ask? Why not just take everything as dividends and avoid payroll all together? Simply stated, you have to process payroll because the IRS said so. They require you to pay yourself a “reasonable compensation”. It is one of the compliance standards and criteria of operating an S corporation.
With that understood, let’s tackle the process of setting up and running payroll, which has a number of steps. The rest of this post will demonstrate the process we walk our clients through. Obviously, if you’re not a client of IC Tax, you may need to take slightly different steps.
Payroll Setup
First and foremost, you need to determine how much “reasonable compensation” is for you. Then, you need to figure out the frequency of your payroll runs. Both of these issues are best discussed with your tax advisor as it is based on what you do, geography, how much you work, and what your financial needs are. These two issues are among the first things discussed with your tax advisor when you become one of our clients.
Part of the purpose of payroll is to pay taxes; FUTA, Social Security, Medicare, state and local withholding taxes. In order to pay your state taxes, your business must be registered with the state’s corresponding tax departments, and then be issued state account numbers for those taxes.
The account numbers you will need vary depending on your state, but in general your business must be registered for Unemployment Insurance tax and state Withholding tax (if there’s an income tax in that state). Each state has their own process to obtain these accounts. We actually obtain these account numbers for our clients, keeping track of the progress, and handling any issues that may arise in the process.
You will need to fill out a Form W-4 and any corresponding state forms for withholding taxes.
Finally, you need to provide the routing and account numbers for your business checking account. Using this information, we initiate three transactions. Two small deposits that vary in amounts, and a withdrawal that is the total sum of the two deposits. Once you see these transactions, you communicate them to us to verify that you are the owner of the account.
Processing Payroll
The above steps are required to set up payroll, but how is payroll actually processed? For our clients, this is how we run payroll:
After the bank accounts have been verified, the tax account numbers have been obtained, and we know the amounts and frequency in which to run your payroll, it’s time to actually run payroll.
Please note, when we process payroll it takes 3-4 business days to move funds from your business account to your personal account. Payroll comes out of your business account in 2 transactions. One is the total net pay of your salary, and the other is the total taxes of your salary, which consists of the employer and employee portions of your taxes.
Because you are paying the employee AND employer portions of your taxes it is important to have 10% extra of what your gross salary is, in your account. So, if your salary is $1,000 each pay period, you should have $1,100 in the account to cover the employer portion of your taxes just to be safe.
Also, we recommend having the funds in your business account a week before your payroll run to avoid having insufficient funds. All of this is done through direct deposit, so there is no paperwork or mail you need to keep an eye out for, and at most you will receive email notifications or a phone call from us letting you know when things are happening. You have direct access to the payroll portal, where you can view your paystubs, and see all the withholding and taxes being taken out.
After payroll funds are withdrawn from your business, you are free to take a dividend of an amount discussed with your tax advisor. Just be sure to leave enough in the account to cover any expenses that you have running through the business account.
Frankly, there’s a lot that goes into running payroll properly and you probably shouldn’t attempt to do it on your own. At Independent Contractor Tax Advisors, we streamline running your business for you, saving you taxes, time and headache. If you want to save taxes, and unload your compliance burden on trained professionals, contact us today for a free tax consultation!
CLICK HERE FOR A FREE TAX CONSULTATION
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