As we continue our series on S Corps, we’ve come to an interesting question: Does an S Corp need to pay payroll taxes? Your short answer is yes. S Corps, even single-member ones, are responsible for payroll taxes just like any other business. However, one of the fantastic benefits of an S Corp is that you can avoid payroll taxes for at least some of the money you make. What Are Payroll Taxes? The term “payroll taxes” refers to the Social Security and Medicare taxes that are withheld from an employee’s paycheck and matched by employers. Here’s how it works: The employer is responsible for covering half of the payroll taxes for each W-2 employee, which is 7.65% of each employee’s pay. Employees will also have 7.65% of their pay deducted from each paycheck for payroll taxes. In total, an amount equal to 15.3% of each employee’s pay must be paid to Social Security and Medicare. What Is Self-Employment Tax? If you own your own business as a sole proprietor, you’ll have to pay self-employment tax. Since you essentially are your own employer, you have to pay both the employee and the employer’s share of payroll taxes. This means that you have to pay 15.3% of your income in self-employment taxes to ensure your share of Medicare and Social Security taxes is covered. A quick note: self-employment taxes and payroll taxes both refer to Medicare and Social Security taxes. They’re just called different names depending on how they are paid, because people like tax law to be unnecessarily confusing. Payroll Taxes And Your S Corp This is where having an S Corp comes in handy. With an S Corp, you can avoid payroll taxes on any profits you make from your business, as opposed to a sole proprietorship – where you have to pony up payroll taxes for 100% of your earnings. Here’s the catch: you can’t just call all of your earnings profits, skip payroll taxes altogether, and call it a day. The IRS requires that, if you work as an employee of your S Corp, you have to pay yourself “reasonable” compensation for your services. What Is ‘Reasonable’ Compensation? That’s a great question! Unfortunately, there’s no great answer. Reasonable compensation isn’t defined anywhere in the tax code. Instead, the IRS will look at the facts of your particular circumstances to determine if your salary is reasonable. If they think your compensation is too low, they can recharacterize your distributions as wages, and you’ll have to fork over payroll taxes. In deciding whether compensation is reasonable, the IRS (and the courts, for cases that go to litigation) will look at factors such as: Your training and experience Your duties and responsibilities The time and effort you spend on S Corp business Your dividend history Compensation amounts for non-shareholder/ non-member employee Local market rates for comparable services In general, the more qualified you are and the more professional services you provide for your S Corp, the higher your salary should be. You definitely want to seek guidance from your attorney or account on this issue because the IRS is notorious for its thorough scrutiny of S Corp salaries and distributions. Payroll Taxes On Your Compensation If you’re paying yourself (salary or wages) and you’re an employee of your S Corp, payroll taxes must be withheld just like any other employer. The S Corp will pick up the employer’s share of payroll taxes, and your share will be deducted from your pay. This means you can’t benefit from the S Corp’s magic payroll-tax-avoiding powers until your business is lucrative enough to pay yourself a reasonable salary AND have some profits left over. Another thing to keep in mind: If you have a health insurance policy through your S Corp, make sure your S Corp is footing the bill. That means the S Corp will have to add your insurance payments as income on your W-2. Qualified Business Income Deduction The qualified business income (QBI) tax deduction lets you deduct up to 20% of your S Corp income on your taxes. Of course, the IRS has put plenty of limitations on who can use this deduction and what type of business income is covered. What Is Qualified Business Income? The IRS defines qualified business income as “the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business.” In other words, it’s your S Corps net profits. This means you can take a QBI deduction on the PROFITS of the S Corp you receive as distributions. You do not get to use the QBI deduction on the SALARY you pay yourself. QBI Income Limits In 2020, your total taxable income must be under $163,300 for single filers or $326,600 if you file jointly with a spouse. In 2021, the limits will increase a bit to $164,900 for single filers and $329,800 for joint filers. Remember — since your S Corp is a pass-through entity, you’ll report its income as your own on your personal income taxes. So these limits apply to your TOTAL taxable personal income and not just the part that comes from your S Corp. If you’re over the income limit, you may still qualify for a full or partial deduction. But these laws are immensely complicated and confusing, so it’s best to contact your accountant or lawyer to discuss if you qualify. Interested in learning more? Check out our article How You Can Save Thousands in Taxes with an S-Corp and Using Your S Corp: Section 179 Deductions.