Each year a few of our bookkeeping clients will have grown to a size where it makes sense for me to recommend that they file as an S Corp. Filing an election to have your LLC or Corporation taxed as an S Corp is a move that can have a lot of benefits, but you may cause problems for yourself by making that election too early and not running it properly.
S Corps, Payroll, and Reasonable Compensation
The most common issues I find with new clients coming to me as S Corps involve payroll. Many S Corp owners have not been paying themselves a salary. This decision has left their businesses ineligible for a Payroll Protection Program loan and left them open to the risk of a Reasonable Compensation Audit.
What business owners often do not know before speaking with me is that you are required to pay yourself a reasonable wage for the work you do for the business. Basically, if you had to hire someone off the street to do what you do for the company, you need to pay yourself at least that much. Instead, I see people paying themselves a salary of $0.
The IRS conducts Reasonable Compensation audits and those can wind up being very expensive after you factor in the penalties and interest.
What does this have to do with my PPP loan application?
The problem here is how the amount that you’re eligible to take out as a PPP loan is calculated. The amount is a function of what is subject to payroll taxes- both formal payroll and business profit that is subject to Self-Employment Tax.
Let’s look at a hypothetical S Corp that has 60,000 in profit with no one on payroll. S Corp profit is not subject to self-employment tax so if you combine that with the fact that there is no payroll being run, the amount of the loan that they are eligible for is $0. If on the other hand, they were taxed as a sole proprietorship they would actually be eligible for a PPP loan of 12,500 and all of that would be forgiven.
What can I do now?
New clients often say that they were told they don’t have to do give themselves a salary, or that they were never advised how to properly operate as an S Corp. Whatever the reason for doing it, it’s done. There is now the risk of a Reasonable Compensation Audit and they’ve potentially missed out on thousands of dollars of PPP funding that could be desperately needed.
Are you operating an S Corp with $0 payroll? Now is the time to regroup and protect your business from further harm. If you're having any trouble with the IRS or your state taxing authority, contact me today. I work with clients locally in Hartford County, CT, and work virtually with clients throughout the country.
Please comment below with any questions about your PPP or EIDL.
Joseph Orabona, EA