5 Year End Payroll Considerations

 In Payroll, Tax Filing

Because the vast majority of small businesses operate on the cash basis of accounting (meaning that expenses are deducted when paid), it can be critical from a tax standpoint whether a transaction occurs on December 31 versus January 1. Generally, a transaction that occurs on December 31 (i.e. before the calendar year closes) is reportable on that year’s tax return, whereas a transaction that occurs a day later is reflected on the next year’s return. Here are 5 questions small business owners should ask themselves with respect to payroll and other somewhat related types of disbursements (distributions to owners, payments to contractors, and payments to landlords) before the year closes.

1. Is Shareholder Compensation Reasonable?

For small businesses that are classified as C or S corporations, shareholders performing services for the corporation must be paid reasonable compensation for services rendered. Failure to pay reasonable compensation is one of the most frequently occurring tax issues that arises with respect to small business corporations. You may ask yourself, “Why does the IRS care whether the shareholder’s compensation is reasonable or not—isn’t that just another deduction for the corporation?” I’m glad you asked! The IRS cares because about a third of the Department of Treasury’s revenue is funded through payroll taxes, and these taxes are significantly more likely to be paid timely throughout the year when compared to estimated tax payments that are not withheld through payroll. When corporations fail to pay shareholders reasonable compensation, the IRS misses out on payroll tax revenue and has to wait longer for money that it should have received regularly throughout the year.

Before the year wraps up, be sure to determine whether shareholders of the corporation who performed services were compensated properly (via wages or salary with applicable payroll tax withholdings) during the year. If all shareholders receive compensation, the next step is determining whether the compensation was reasonable for the services rendered. If you aren’t sure whether your corporation was required to pay compensation to its shareholders or whether the compensation paid was reasonable, be sure to check in with your tax adviser.

2. Have You Taken Distributions, Can You, and Should You?

This consideration is applicable to any small business owner—whether you are taxed as a sole proprietorship, partnership, C Corporation, or S Corporation. Most business owners are in business to receive financial remuneration for their efforts. Oftentimes, part of the owner’s payment received results from distributions of company profits. Whether the money is distributed to the owner on December 31 versus January 1 can be significant taxwise. This is especially true if the company experienced a loss during the tax year, as it can impact whether that loss is deductible on the taxpayer’s individual tax return and whether a dividend or other distribution is even permissible for the company. As mentioned previously regarding shareholder compensation, impermissible and improperly paid distributions are another frequently occurring problem with small businesses.

Before the year is up, if you are not sure whether your business has a profit or loss, whether your company is permitted to pay distributions, or what to do about distributions that you may not have been allowed to take, be sure to check in with your tax adviser.

3. Are Your Year End Payroll Reports Going to be Accurate?

I recommend to each of my clients to use the major payroll processing services to facilitate their payroll compliance—given the efficiency of these services and the relatively low costs associated with them. However, because the commonly used payroll services involve significant automation, the old phrase of “garbage in, garbage out” comes to mind with respect to payroll reports filed in these systems. When things go awry, it can be very costly and frustrating to fix payroll tax reports once they are already filed incorrectly. Here are some things you should check before the year closes and the final reports are filed:

  • Are the employer’s business name, address, EIN, withholding and unemployment IDs, other demographic information, and tax rates entered correctly in the payroll system?
  • Are the employees’ names, SSNs, addresses, pay rates, withholding allowances, and other demographic information entered correctly in the payroll system?
  • Did any payrolls occur outside of the payroll system that need to be entered into the payroll system?
  • Did you switch payroll providers midway through the year, and if so, which one(s) are filing reports? Your employees will not be happy if their income is reported double to the IRS, if withholding they paid does not get credited to their accounts, or if they are unable to qualify for credits, deductions, etc. based on inaccurate payroll information submitted to the IRS.
  • Do you as the employer have to go into the payroll system to physically release and report W-2s, 1099s, and other payroll forms or does your payroll provider initiate such filings on your behalf automatically? There are benefits and drawbacks to both options!

4. Are You Required to File Forms 1099-NEC or 1099-MISC?

Another thing to consider before the year closes is whether you paid any individual or company $600 or more, and whether that payment requires you to file Form 1099-NEC or Form 1099-MISC. While this technically is not a “payroll” issue, I’ve heard my small business clients refer to contractor payments as “payroll” many times over the years, so I’m including it here on that basis. Though small business owners are typically aware that Forms 1099-NEC may need to be filed for payments to independent contractors, many do not know that Forms 1099-MISC may be required for rents paid by the business. It’s another frequent oversight that occurs with small business owners, and I have seen taxpayers selected for audit by reporting rents on their return and not filing a Form 1099-MISC when required. If you are not sure whether you need to file these forms, be sure to consult your tax adviser.

5. Are New Tax Rates, Forms, or Filing Frequency Changes Applicable for 2023?

During November and December, the IRS and many state tax authorities begin sending out letters to employers, payers of sales tax, and other small business owners regarding updated rates, changes in the forms required to be filed, changes in the frequency of payroll or sales tax deposits (i.e. quarterly deposit updated to bi-weekly deposit requirement), and filing frequency changes (i.e. quarterly filer updated to annual filer) that will be applicable in the new year. Did you receive any of these letters? Did you not receive these letters but believe that you probably should have? Be sure to always keep your address updated with the relevant tax authorities so that you will be aware of these changes, and be sure to update them in your payroll system as soon as they become applicable in the new year. Paying in at the previous year’s rates can result in overpayments that take significant time and effort to get back, and filing/depositing at the improper frequency can result in penalty and interest assessments—not to mention the unnecessary frustration for the business owner that results from reading and responding to tax notices and placing calls to government agencies.

If you are a current or prospective client who needs to check in with me regarding any of these issues and would like to schedule a year-end consultation, please contact me using the form below. Wishing everyone an enjoyable holiday season, a smooth and effortless year end, and a happy new year!

 

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