Do I Pay Payroll Taxes?
Payroll Problems: The Tax Traps Business Owners Cannot Afford to Ignore
Payroll seems simple enough: pay yourself, pay your employees, send some money to the government, and move on.
Unfortunately, the IRS did not design payroll to be simple.
How a business owner gets paid depends on how the business is taxed. A Schedule C business owner, a partner in a partnership, and an S-corporation shareholder cannot all pay themselves the same way. Using the wrong method can create amended returns, back payroll taxes, penalties, interest—and one very expensive headache.
Let’s break it down.
Schedule C: You Are Not Your Own Employee
A sole proprietor or the owner of a single-member LLC taxed as a disregarded entity generally reports business income and expenses on Schedule C of Form 1040.
The owner does not put themselves on payroll. They do not receive a W-2 from their own Schedule C business. Instead, they take an owner’s draw.
An owner’s draw is not a business expense. If you transfer $5,000 from the business account to your personal account, the transfer does not reduce business profit. Your taxes are based on the business’s net profit—not how much cash you withdrew.
For example, suppose your business earns $150,000 after deductible expenses, but you only withdraw $80,000. You are still generally taxed on the entire $150,000.
Schedule C net earnings are used to calculate self-employment tax on Schedule SE. Self-employment tax generally covers the Social Security and Medicare taxes that would otherwise be split between an employer and employee. A self-employed person generally owes self-employment tax when net earnings reach at least $400. The tax is calculated as part of the owner’s individual Form 1040 filing. IRS Schedule SE instructions
Because there is no employer withholding taxes from an owner’s draw, Schedule C owners may need to make quarterly estimated tax payments. A common tax trap is waiting until the annual return is prepared to discover that the business made a healthy profit—but the owner saved nothing for taxes.
Success is wonderful. A surprise five-figure tax bill is less wonderful.
If the Schedule C business has employees, however, the business must establish payroll for those workers, withhold the required taxes, make timely deposits, and file the applicable payroll tax returns.
Partnerships: Partners Are Not W-2 Employees
A partner is generally not an employee of the partnership. The partnership should not issue the partner a W-2 merely because the partner works in the business. The IRS specifically states that partners should not receive Form W-2 instead of Schedule K-1 for distributions or guaranteed payments. IRS guidance on paying business owners
A partnership may compensate a working partner through a guaranteed payment. This is commonly used when a partner receives a fixed amount for services, regardless of whether the partnership earns a profit.
Guaranteed payments are reported on the partnership’s Form 1065 and the partner’s Schedule K-1. Guaranteed payments for services are generally subject to self-employment tax.
In addition, a general partner’s share of ordinary business income is generally included in self-employment earnings. The rules for limited partners and LLC members can be more complicated. A person who qualifies as a limited partner generally pays self-employment tax on guaranteed payments for services but not necessarily on the person’s distributive share of partnership income. The title “limited partner,” however, does not automatically settle the federal self-employment-tax question. The owner’s authority, services, participation, and legal rights may matter. IRS partnership filing instructions
Another common mistake is confusing a distribution with compensation. A distribution is generally a withdrawal of partnership cash or property. A guaranteed payment compensates a partner without regard to partnership income. A distributive share represents the partner’s allocated portion of partnership activity.
These items can have different effects on taxable income, self-employment tax, tax basis, and capital accounts. Calling every payment a “draw” does not make the differences disappear.
Partners generally do not have federal income tax withheld from K-1 income. They may need to make quarterly estimated tax payments, just like Schedule C owners.
S Corporations: Reasonable Compensation Comes First
An S corporation changes the payroll picture.
A shareholder who provides substantial services to the corporation is generally an employee. The corporation must pay the shareholder-employee reasonable compensation through payroll before treating additional payments as non-wage distributions.
Reasonable compensation is not simply whatever amount the owner would prefer to report. It should reflect factors such as:
The owner’s duties and responsibilities
Time devoted to the business
Experience and training
Comparable compensation for similar work
The company’s size, location, and profitability
Compensation paid to non-owner employees
The source of the corporation’s revenue
The IRS may reclassify distributions as wages when an S corporation pays little or no salary to a shareholder who performs services. That can create back payroll taxes, penalties, and interest. IRS guidance on S-corporation compensation
At the other extreme, paying an unnecessarily high salary may increase payroll taxes and reduce the intended tax benefit of the S-corporation structure.
Reasonable compensation should be calculated and documented—not pulled from thin air five minutes before the final payroll of the year.
Shareholder wages are subject to payroll withholding and reported on Form W-2. The remaining business profit generally passes through on Schedule K-1. S-corporation distributions are not a substitute for wages, and distributions do not count as earned compensation for retirement-plan contribution purposes. IRS retirement-plan guidance
Depositing Payroll Taxes Is Not the Same as Filing Payroll Forms
One of the biggest payroll misunderstandings is believing that submitting the money completes the job.
It does not.
Employers generally withhold federal income tax and the employee’s share of Social Security and Medicare taxes. They must also pay the employer’s share of Social Security and Medicare taxes. These amounts are deposited according to the employer’s required deposit schedule.
The employer must separately file payroll tax returns reporting the wages, withholding, and taxes. A payment does not replace a return, and a return does not replace a required deposit.
Form 941
Most employers file Form 941, Employer’s Quarterly Federal Tax Return. It reports wages, federal income tax withheld, Social Security tax, Medicare tax, and other applicable payroll information.
It is generally filed four times per year, even if a payroll processor already made the tax deposits.
Form 944
Form 944 is the annual alternative for certain very small employers. It is not a form an employer may casually choose because annual filing sounds easier.
Generally, the IRS must notify the employer that it is eligible or required to file Form 944 instead of Form 941. Employers usually cannot switch between the forms without IRS approval. Form 944 is intended primarily for employers whose annual employment tax liability is expected to be $1,000 or less. IRS Form 944 instructions
Filing Form 944 when the IRS expects Forms 941 can leave four apparently missing quarterly returns on the business’s account.
Form 940
Form 940 reports federal unemployment tax, commonly called FUTA. It is generally filed annually and is separate from Form 941 or Form 944.
Employers may receive a credit for timely state unemployment tax payments, potentially reducing the effective FUTA rate. Late or incorrect state unemployment payments can affect that credit. IRS Form 940 guidance
Employers must also address Form W-2, Form W-3, state withholding returns, state unemployment filings, and any required local payroll filings.
The Most Expensive Payroll Tax Traps
Common payroll problems include:
Paying an S-corporation shareholder entirely through distributions
Issuing a W-2 to a partner for work performed as a partner
Treating employees as independent contractors
Making payroll deposits but failing to file Forms 941, 944, or 940
Filing Form 944 without IRS authorization
Using payroll tax money to cover other business expenses
Missing state payroll or unemployment registrations
Forgetting year-end Forms W-2 and W-3
Running one large year-end payroll without checking deposit deadlines
Assuming the payroll company is responsible for every error
The consequences can include failure-to-file penalties, failure-to-pay penalties, failure-to-deposit penalties, interest, corrected W-2s, amended payroll returns, state assessments, and worker-classification disputes.
Even worse, taxes withheld from employees are considered trust fund taxes. Responsible individuals who willfully fail to collect, account for, or pay those taxes may face personal liability through the Trust Fund Recovery Penalty. Closing the company does not necessarily make that exposure disappear.
Get the Structure Right Before Moving the Money
Payroll is not merely writing checks. It connects entity taxation, worker classification, withholding, retirement contributions, unemployment taxes, and federal and state reporting.
Before paying an owner, first determine how the business is taxed. Then identify whether the payment is an owner’s draw, guaranteed payment, partnership distribution, W-2 wage, or S-corporation distribution.
The name entered in the accounting software does not control the tax treatment. The underlying facts do.
When payroll is handled correctly from the beginning, it becomes a routine business system. When it is ignored until tax season, it can become a costly cleanup project.
And trust me: payroll is much more enjoyable when we are planning it than when we are reconstructing it.
Need help? Book a call with Lisa Brugman EA & Associates.
