An S Corporation Election With No Payroll: Fixing Salary and Late Returns

This scenario is an illustrative composite of a situation taxpayers commonly face. It is not a record of any client engagement, and it is not tax, legal, or accounting advice. Rules, thresholds, and IRS procedures change, and every situation depends on its own facts.

The S corporation election is one of the most common tax-saving moves for a profitable creator. It only works when the structure is run properly: a salary through payroll, payroll tax filings, and a corporate return every year. When the election is made and nothing else follows, the savings can turn into a backlog of filings and penalties.

The situation

A content creator's income grows, and he is told that an S corporation election will reduce his self-employment tax. He files Form 2553 for his limited liability company. After that, he pays himself only by transferring money from the business account as owner distributions.

He never sets up payroll, files no payroll returns, and files no S corporation returns. His personal returns either report the business on Schedule C or aren't filed at all. Three years later, he isn't sure whether the IRS ever accepted the election.

How an S corporation is supposed to work

An S corporation doesn't pay federal income tax itself. Its profit passes through to the shareholders on Schedule K-1. The tax saving comes from the split between salary and distributions:

• Salary paid to an owner who works in the business is subject to Social Security and Medicare taxes through payroll.
• Distributions of the remaining profit are not subject to those taxes.

That split only holds if the salary is reasonable for the work the owner performs. Paying no salary at all and taking everything as distributions is the pattern the IRS challenges most often. Revenue Ruling 74-44 and court decisions such as David E. Watson, P.C. v. United States (Eighth Circuit, 2012) have recharacterized distributions as wages in exactly this situation.

What's at stake

Recharacterized wages. The IRS can treat part or all of the distributions as wages. That brings back the employer and employee shares of Social Security and Medicare tax, plus failure-to-deposit penalties under section 6656, which range from 2% to 15% depending on how late the deposits are.

Late S corporation returns. Form 1120-S is due March 15 each year. A late return carries a penalty under section 6699, charged for each shareholder, for each month the return is late, for up to 12 months. This applies even though the corporation itself usually owes no income tax.

Mismatched personal returns. If the election is valid but the personal return reported the business on Schedule C, the returns don't match the IRS's records of the entity's status.

A defective election. If the election was never accepted, the business is not an S corporation for those years. Every year would then be taxed as a sole proprietorship, with self-employment tax on all net profit.

How it's typically resolved

### 1. Confirm the election status The IRS sends an acceptance notice (typically a CP261) when an S corporation election is approved. If that notice can't be found, the status can be confirmed with the IRS directly. Everything else depends on this answer.

### 2a. If the election is valid: build the payroll history Set a reasonable salary for each year. The analysis looks at the owner's duties, hours, and experience, what comparable roles pay (Bureau of Labor Statistics data and industry surveys are common references), and the business's revenue and profit. There is no fixed percentage rule. The "60/40" split often quoted online has no basis in the tax code.

Then file the missing payroll returns:

• Form 941 for each quarter, reporting the wages and the Social Security and Medicare tax.
• Form 940 for each year, for federal unemployment tax.
• Form W-2 for each year, issued to the owner and filed with the Social Security Administration.
• State payroll registrations and returns, including state unemployment insurance.

Because no income tax was withheld at the time, the owner reports the wages on his personal return and pays the income tax there. Under section 3402(d), the corporation's liability for the unwithheld income tax can be relieved once the owner shows the tax was paid, using Forms 4669 and 4670.

### 2b. If the election is defective: decide whether to save it Revenue Procedure 2013-30 provides relief for late or defective S corporation elections, generally within three years and 75 days of the intended effective date, where there was reasonable cause and the business intended to be an S corporation. Whether relief is worth requesting depends on comparing the payroll catch-up cost against the self-employment tax on a sole-proprietorship basis.

### 3. File the S corporation and personal returns File the late Form 1120-S returns with the salary deduction and employer payroll taxes included, and issue Schedule K-1s. Then file or amend the personal returns so the wages, the K-1 income, and any health insurance paid for the owner (included in W-2 wages for owners above 2%) all match.

### 4. Request penalty relief First-time abatement can apply to the S corporation late-filing penalty and to payroll failure-to-deposit and failure-to-file penalties. It is applied by return type and period, usually to the earliest one. Remaining periods need reasonable-cause relief.

Common mistakes

• Paying no salary while taking regular distributions.
• Paying a salary by bank transfer without filing payroll returns.
• Filing Schedule C on the personal return while the S election is valid.
• Assuming a state recognizes the federal election automatically. A few states require their own election or tax S corporations differently.
• Basing retirement plan contributions on distributions. They are based on W-2 wages.

What to gather before starting

• Form 2553 and any IRS acceptance letter
• Business bank statements showing all owner transfers
• Any personal returns filed for the years in question
• Profit and loss figures for each year
• A description of the owner's role and hours

Typical outcome

When the election is valid, the S corporation can usually be preserved, with a documented salary, payroll filings, and corporate returns brought current. The tax benefit of the structure continues going forward on a defensible basis. When the election is defective, relief can often be requested, or the years can be reported correctly as a sole proprietorship, whichever produces the better result.

Frequently asked questions

### Is there a safe salary percentage for an S corporation owner? No. Reasonable compensation depends on the work performed and what it would cost to hire someone to do it. Percentage rules of thumb are not in the tax code.

### Can I just revoke the S election? Yes. Revocation requires consent from shareholders holding more than half the shares. After revoking, the business generally can't re-elect S corporation status for five years without IRS consent.

### Will fixing this trigger an audit? Filing late returns doesn't automatically trigger an audit. Correcting the filings before the IRS raises the issue generally puts the business in a better position than waiting for a notice.

### Does a lower salary always save tax? Not always. A lower salary reduces payroll tax but can also reduce the qualified business income deduction and the room for retirement plan contributions. The figures should be run both ways.

Next step

If you made an S corporation election and aren't sure the setup behind it is complete, book a free fit call to review where things stand.