Throughout this book we make reference to running payroll quarterly. Before we discuss the reasons why, if you have a staff where payroll is ran every two weeks the quarterly S Corp payroll concept might still apply so please keep reading.
The most important consideration is that you do not have to wait for payroll to get cash. Remember, as an S corporation owner you wear two hats- employee and investor. As an investor, you receive distributions from the business. As a controlling investor, you also dictate the frequency and amount of those distributions. Therefore, if you need cash from the business to pay for groceries, mortgages, diapers, etc., then declare a shareholder distribution.
A huge word of caution is in order however. The IRS and Tax Court do not like to see you use your business as an ATM machine. This is not because you just said automated teller machine machine. This is because the spirit of a shareholder distribution is to be a return on investment, and if it is magically tied to personal living expenses it looks bad. Think of it this way- you wouldn’t call up Google and demand a dividend because baby needs new shoes. Same thing here.
Another perspective- Apple shareholders are routinely upset because of the cash that Apple hoards. There are two ways to get a return on investment- capital appreciation (and subsequent sale) and dividends. If there are piles of cash and there aren’t immediate or mid-term needs for the cash, shouldn’t that be returned to investors who helped build the cash to begin with?
What do you do? One option is to take systematic distributions throughout the year, and flush out the remainder once a quarter or annually. Another option is simply take large chunks periodically without any cadence or basis that can be tied to personal living expenses.
As a side note, lenders do not like to see a bunch of cash in your S corporation bank account. If you are looking to buy a house in the next six months, drain your business bank account down to the operational minimum. Lenders see $100,000 in the business account and they assume the business needs this. You roll up and say you are going to take it all out for a down payment. Now the sales prevention team (i.e., underwriting) thinks your business will suddenly fail which cuts off your ability service your debt. Next thing you know we have to write letters explaining that your business won’t fail and it becomes a big headache for everyone.
Here is another consideration. If you pile up money for a handful of years, and then flush it all out in one year, the relationship between income, reasonable shareholder salary and distributions will be unbalanced. Keep in mind that one of the criteria the IRS and the Tax Court uses to test the reasonableness of a shareholder salary is the comparison between salaries and distributions. You don’t get rollover credits for all those years where you didn’t take out distributions, and while you can demonstrate the problem in support of your salary why have the conversation at all?
Bottomline- do not leave cash laying around in your business. Put that money to use, or put it in your personal savings account or retirement fund. Business owners routinely use their business checking account as a personal savings account. Bad. Don’t do it. Run your business like a business, and make sure retained cash has a purpose! Idle business cash has very little upside unless you have a capital expenditure or some other near-future use.
Some accountants will simply run S Corp payroll once a year. In our opinion, this is bad for three big reasons-
Running payroll quarterly also helps us stay ahead of your potentially silly ideas. If we communicate on a quarterly basis, we can prevent you from buying a car in your personal name when it is 100% business use. Or we can talk you out of a SEP IRA when a solo 401k plan is preferred (you are permitted to have both in the same year if they are both sponsored by the same business). There are thousands of ideas that sounded great at the time just to find out later that there was a better option. Quarterly payroll and the client communication that goes along with that helps everyone.
Most importantly, we can help you understand your impending tax obligation as we gather your net income data each quarter. We tell people bad news all the time, especially around March. However, we never want you to be surprised by it. We do mid-course corrections in Q3 since we have enough history to predict the future, and clean-ups in Q4.
If you are already running payroll every two weeks because you have a staff (or you are considering getting a staff), there are two options. We can worm your salary into the frequency of everyone else’s payroll, or we can inject your quarterly payroll into one of the normal payroll runs prior to the quarter end. More discussion is required, but it is simple either way. Next we turn to the computation of a reasonable S Corp salary.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition