USA S-Corp first year payroll and depreciation

[prekteacher]

My wife and I run a preschool that is an S Corp. We incorporated in February of 2024, but began having students in September. She and I are the only employees of the business and are 50/50 owner/members. From a cashflow perspective, we will show a small loss this year, nearly breaking even, and we have not yet cut ourselves any payroll checks.

My first question- Since, in this scenario, we have no profit, are we still required, under S-Corp regulations, to pay ourselves?

We will show a profit in 2025, which I would like to reduce by not fully depreciating the schools furniture and educational materials purchased this year (2024). If I do this, we then will show a profit in 2024 and I'm wondering about the consequences for 2024 S-Corp payroll requirements.

If we decide to go this route, is it allowable to cut ourselves payroll checks in January, after the tax forms are nearly complete but not filed, which we would then expense to 2024? This would give us time to deposit FICA, FUTA and SUTA before January 31st deadlines. It a matter of $7k or so in the question of full depreciation and a loss in 2024 versus partial depreciation and some payroll in 2024. Or, do we need to estimate the payroll and cut a check in December if we go with partial depreciation? Or, is there some other major factor I've overlooked or misunderstood? Thanks

 

[DrStrangeLove]

Yes, you have to pay yourselves. Even employee-owners have to be paid "reasonable compensation" for the value for the non-owner services they perform for the S-corp, regardless of whether the S-corp is profitable. This is an anti-abuse doctrine consistently held by the courts, the result of S-corp owners' trying to avoid paying payroll taxes by not paying themselves for non-owner services rendered or by characterizing the amounts they paid themselves as owners' drawings. The risk of being audited if you don't take pay for your non-owner services is very high, since this is a well-known, well-litigated issue with S-corps and employee-owners, and the IRS has the authority to recharacterize owners' drawings as salary paid if they determine that you avoided taking salary to avoid paying payroll tax. These are not the dice to roll.

When you say you want to not fully depreciate the furniture and materials, do you mean you don't want to depreciate the full cost under Sec 179 and bonus depreciation? Or that you don't want to take all the depreciation under MACRS for tax purposes?

Sec 179 and bonus depreciation are elections, so you don't have to take them if you don't want to. But you can't then come back next year and claim them. Normal depreciation, though, isn't optional; once assets go in service, the clock starts running, and they get depreciated. Now, depending on when you opened your doors to offer services, you might be eligible only for a partial (half? quarter?) year of depreciation anyway, especially if you opened your doors later in the year. When did the business open its doors and start operations? That will tell you how much time over which you can take depreciation. (The method is still an open question.)

Sounds like you need to hire a CPA licensed in your area to help you with these questions.

 

[prekteacher]

Thanks for your reply. Yes, I was referring to section 179 when I mentioned fully depreciating vs MARCS. I understand the need to put the two owners on payroll and pay us a reasonable salary so as not to abuse the tax benefits of S-Corps, but I'm asking myself where the money should come from as currently, with no payroll, we are almost breaking even.

My readings on how the IRS determined a reasonable salary say that there is no single formula, but it is based on a typical salary for the same job in our area and that also the total earnings of the business are considered, such that a higher earning school would need to pay its owner-teachers more, despite doing the same job as a teacher in a lower earning school. It was my hope, that in our situation, the IRS would recognize that not taking a salary is not a method of avoiding SE taxes by shifting earnings to distributions, but is simply a practical matter of not having the earnings to support a salary. Indeed, no distributions will be taken.

Should we borrow money to pay ourselves salaries that would be typical in order to comply with the salary requirements? Or, if I take depreciation and show a profit this year, is it acceptable to write a payroll check in the amount of the profit?

We did open our doors to students in September, so assets will be in use for 1/3 or a year. Since I would like to maximize future expenses, is MARCS the best method?

Thanks again

 

[DrStrangeLove]

Without having seen your financial/GAAP books, from what you wrote, it sounds like you have a liquidity crunch to fix. That's more of a problem than depreciation. I'd suggest you talk to your S-corp's banker (if you have one) and see if you can get a short-term note payable, a short-term loan or a credit line to see you through till you can convert some receivables. I'd also talk to your CPA (if you have one) about a strategy for managing liquidity over the next couple years.

There isn't a single formula for determining a reasonable salary, but you do need to look at the local market and use something reasonably similar to it. The fact that you just started your business may helps your case for a somewhat lower figure at first for a year or two. And the fact that you've been open for only a few months means you'd have paid only a part-year's salary. But when scaled up to an annual basis, it still has to be a reasonable figure. (Imagine you're a stranger to the business who's applying for that job, and that amount is what you're offered. Would you really take it? How long would you stay at that job knowing that you're making significantly less than market? Be honest here.) If you're paying 90% of market, no one will sniff at it. If you're paying 15% of market...that has a different smell altogether. The farther away from market your figure is, the higher your audit risk for this item.

MACRS is your only choice here if you're not electing Sec 179. From your original post, you're looking at using the GDS (general depreciation system), not ADS (alternative depreciation system), and double declining balance. There's a mid-month convention you'll need to use to calculate the right amount. There's also a business income limit on the amount you can take. I'd suggest you look at IRS Publication 946 to see how to do it, or talk to your CPA about the details. (It's a non-trivial calculation, but it's up to you.)