1. S Corporations and Employees
2. Must Your Corporation Pay Salaries?

Does a corporation have to have employees? No, there is no legal requirement that a corporation has to hire employees. In fact, many corporations will not need employees. If you do decide to hire employees for your corporation, however, there are several tax and reporting requirements with which you must comply.

S Corporations and Employees

An S corporation is a corporation that has made a special Internal Revenue Service tax election. S corporations are not directly taxed and are instead considered pass-through entities, which means corporate profits are taxed on shareholder's personal returns. An S corporation is able to hire employees, but employees are not a requirement.

S corporations get taxed the same as partnerships and sole proprietorships. All three of these entities enjoy pass-through taxation. All profits of an S corporation get taxed on shareholders' annual individual returns. Generally, this leads to a much lower tax burden than a normal C corporation.

If an S corporation chooses to hire employees, the business is subject to a variety of employment-related taxes and payments. In addition to contributions for unemployment insurance, S corporations with employees must pay FICA taxes for Medicare and Social Security. Withholding income taxes from employee wages is also required.

In many cases, S corporations will not have traditional employees, meaning someone that does work in the business for a wage. That said, shareholders that perform work within the company can be treated as employees for tax purposes. In these situations, any dividends given to the shareholder-employee would count as income and be subject to taxation.

If your S corporation has shareholders that do work for the company and you would like to lower your tax burden, you can split their compensation. One half of the shareholder-employee's compensation will be a traditional salary, and the other half will be dividends. Make sure that the salary reasonably compensates the person for their work or else you may face an IRS challenge.

Must Your Corporation Pay Salaries?

After forming your corporation, you are not required to hire employees, which also means you aren't required to pay salaries. As long as your Secretary of State has your Articles of Incorporation and you are maintaining your corporation's Good Standing, your corporation will legally exist.

If your corporation is conducting business, however, the IRS requires your business to have a representative that exercises the company's rights. This person must receive compensation for their work, and this compensation would count as a salary and make the company representative an employee.

There are multiple factors to consider when trying to determine whether your corporation should hire employees:

  • Legal Authority: The laws of the state where you form your corporation govern how you can run your business. As distinct legal entities, corporations have a variety of legal rights, including the ability to hire employees. This means that a corporation can have zero employees or can hire hundreds, or even thousands, of people.
  • Existence in Perpetuity: A corporation exists once it has filed Articles of Incorporation. Until a business has filed this document, it is not treated as a corporation, even if it is acting as one. Corporations exist until the filing of Articles of Dissolution and until formation documents are no longer kept with the state.
  • Withdrawal of Ownership: In the early stages of a corporation, owners will commonly work within the business until they can hire employees. Although owners can draw a salary, they are not required to, and they can work for the business for free. It is possible, however, for owners to take dividends or withdrawals as compensation and to avoid payroll taxes. This practice, unfortunately, may cause problems with the IRS, even though it is legal.

The 60/40 rule is something you should make sure you understand when it comes to corporate employees. The IRS wants to be certain that it receives all required payroll taxes. If corporations were legally allowed to define all payments as dividends, it would drastically reduce the payroll taxes collected by the IRS.

While corporations can function perfectly well without paying any salaries, someone is doing the work of running the business, and the IRS considers these people employees. The 60/40 rule guarantees that the IRS will be able to collect some payroll taxes from corporations run by their owners. If the owners run a corporation and receive dividends instead of a normal salary, the IRS considers 40 percent of this money a dividend and the remaining 60 percent a salary.

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