It is a common scenario. A current client elects S Corp status but forgets to tell you, or a new S Corp client comes your way in the new year. Both have taken distributions but NO reasonable compensation.
Do you advise paying wages via W-2 or 1099-NEC?
Answer: W-2 [It’s the Law see below]
That being said there are times when it may make more sense to beg for forgiveness than to comply.
If you go the W-2 route and file the payroll reports late there will be significant penalties. In this scenario, it may make sense to file 1099 for the shareholder. The shareholder will then pick up the income on the individual tax return as Schedule C income, subject to self-employment tax. There may be a penalty for late filing of 1099, however, that will be less than the penalty for late filing and late paying of payroll tax returns. If you elect to take this path it is important that the taxpayer starts paying themselves correctly via W-2. In our experience, most agents will see that the taxpayer is trying to be compliant and typically forgives the one-time 1099 payment.
But (we are reading your mind here) Paying wages via 1099-NEC instead of W-2 has no tax effect! So why does anybody care?
Generally, the tax is the same, if you’re considering only FICA taxes, but not always. There are a couple of key situations to consider:
- If the shareholder/ employee has another W-2 and now the shareholder’s total wages are over the social security maximum, then the Federal Government is not getting the extra employee portion of the Social Security over the maximum.
- Starting in 2018 the amount that is on 1099 which will be reported on the shareholder’s Schedule C now will have the 199A deduction applied to it. You may be able to override the tax software to show that this 1099 income is not “Qualified Business Income. However, other government entities, both state and local, also want their slice of the pie.
Plus, It’s the law.
- FS-2008-25 states: Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act), and federal income tax withholding under the Internal Revenue Code.
- Generally, an officer of a corporation is an employee of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages.
Just to be certain we looked up the IRS definition of Employee and Independent Contractor, just to make sure there wasn’t some loophole or wiggle room to argue for independent contractor status.
- Employee: Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control how the services are performed.
- Independent Contractor: The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.
The IRS takes this issue very seriously and does not hesitate to assess hefty interest and penalties to folks who don’t comply. The IRS will reclassify all 1099 payments made to S Corp owners as W-2 wages. This means that there are several months, sometimes even years of payroll taxes that the S Corp will now have to pay including the following:
- Back taxes for payroll taxes
- Interest on payroll taxes
- Penalties for failure to file quarterly Forms 941
- Penalties for failure to timely pay the tax withholding to the IRS
- Penalties for failure to file and issue Form(s) W-2
- PLUS, Back taxes for state and local payroll filings, interest, and penalties
Last, don’t overlook your State’s interest in having compensation paid via W-2. States generally have more at stake when it comes to unemployment tax and some states are aggressively going after that revenue. When the state successfully forces the taxpayer to re-categorize 1099 payments as W-2 wages the audit train begins rolling – next stop the Internal Revenue Service.
In sum, report income on the correct form. If you’ve been reporting shareholder-employee income on 1099, take a careful look at your practice and make a New Year’s Resolution to file the correct form going forward.