Running a business-of-one often involves wearing many hats, but once you elect S Corp status, you officially become an employee of your own company. This transition introduces a dual responsibility: paying yourself a “reasonable salary” through a formal payroll system while also managing payments to external contractors who help your business grow.
Understanding the distinction between these two payment streams is essential for staying in good standing with the IRS and unlocking the tax savings that make the S Corp structure worthwhile.
Understanding Your Two Payment Streams
As an S Corp owner, you are managing two different types of professional relationships that require completely different processing methods:
- Owner Salary (W-2 Employee): This is your regular paycheck for the services you provide to your business. It requires formal tax withholdings (Social Security, Medicare, and income tax), regular pay cycles, and quarterly payroll filings.
- Contractor Payments (1099 Contractor): These are amounts paid to independent contractors for specialized services. These payments bypass your payroll system entirely and create a separate trail of invoices and payments.
| Aspect | Owner Salary (W-2) | Contractor Payment (1099) |
| Processing | Through a formal payroll system, like Gusto, Paychex, ADP | Separate payment (ACH, check, Zelle/Paypal, etc.) |
| Tax Withholding | Yes (Income tax + 7.65% Payroll Tax) | No withholding by the business |
| Employer Tax | Yes (7.65% Payroll Tax + FUTA) | No employer tax obligation |
| Year-End Form | Form W-2, any amount | Form 1099-NEC, when total payments are more than $2,000 to any individual/year* *For the 2026 tax year |
The Big Distinction: True Payroll vs. Contractor Payments
The fundamental difference lies in how the money leaves your business account and who is responsible for the taxes.
Running Payroll for yourself as an employee is a structured, IRS requirement for maintaining your S Corp tax status. It generally includes:
- Choosing a payroll software: Using a system to automate withholdings and generate pay stubs and payroll tax returns
- Registering as an employer: Ensuring your business is set up as an employer with the appropriate state and federal agencies
- Setting up employees: Onboarding yourself as the S Corp owner-employee
- Setting salary and cadence: Choosing a “reasonable salary” based on industry benchmarks and establishing a consistent schedule (usually monthly or semi-monthly)
- Ongoing compliance: Maintaining payroll runs, filing quarterly payroll tax returns (federal and state), and completing annual tax filings.
Paying Contractors is a much more flexible “cash-out” process. You can pay via any method – business checking, Zelle, or PayPal – and you do not withhold any taxes. Instead, you simply track the total paid to each individual. Because contractors are self-employed, they are responsible for recording their own income and paying their own estimated taxes, just as you do with your business distributions.
When is someone a Contractor vs. an Employee?
Getting worker classification right is critical; misclassifying a worker can lead to IRS penalties and audits. Here are the high-level indicators:
- Employee: You likely have an employee if you control how, when, and where the work is done, provide the tools and training and the relationship is ongoing and full-time
- Contractor: A worker is generally a contractor if they perform specialized work outside your core business, use their own tools, set their own schedule, and work for multiple clients on a project-based or short-term basis
Year-End Reporting Requirements
Regardless of how much you pay yourself, you must issue yourself a Form W-2 at year-end. For contractors, the reporting threshold has been updated: for the 2026 tax year, if you paid any individual more than $2,000, you are required to file a Form 1099-NEC with the IRS and provide a copy to the contractor by January 31.
Pro-Tip: Always collect a Form W-9 from a contractor before you send the first payment. This ensures you have their correct taxpayer identification number and address on file for year-end reporting.
S Corp Compliance Checklist
Ongoing & Monthly Tasks
- Process Salary Payroll: Run your owner-employee payroll consistently through a formal system.
- Remit Payroll Taxes: Ensure federal and state taxes are withheld and deposited according to your specific filing schedule.
- Collect W-9s: Get a signed Form W-9 from every new contractor before issuing their first payment.
- Track Contractor Totals: Monitor payments made to individuals to identify who will require a 1099-NEC at year-end.
Quarterly Deadlines
- File Form 941: Report federal withholdings on a quarterly basis. State payroll tax returns may also apply.
- Pay Estimated Taxes: Review your profit and loss statements to make accurate quarterly estimated tax payments.
Annual Year-End Requirements
- Issue Form W-2: Finalize year-end payroll and provide your W-2 by the January deadline.
- Issue Form 1099-NEC: Tally contractor payments and issue forms to those who met the reporting threshold by January 31.
- File Form 1120-S: Coordinate with your tax preparer to file your S Corp’s annual income tax return.
The Bottom Line
Managing payroll as an S Corp owner while hiring contractors requires two separate systems, but they are designed to work in parallel. Your owner salary is a mandatory, consistent obligation taxed through withholdings, while contractor payments are optional business expenses with separate reporting requirements. By keeping these streams distinct from the start, you protect your business from penalties, keep your books audit-ready, and preserve the significant tax benefits of your S Corp status.
How Collective Simplifies Payroll
Collective’s embedded payroll solution, powered by Gusto, makes it easier to pay yourself the right way without taking on the administrative lift. We help with employer registrations, guide you toward a reasonable salary range and ensure your payroll is set up to run smoothly from the start.
Once live, payroll runs on a consistent cadence with automated tax filings, and your salary flows directly into your books for clear, reliable financial reporting. It’s a structured foundation that supports better planning, stronger visibility and a business built for long-term growth.
Disclaimer: The information contained in this document is provided for informational purposes only and should not be construed as legal, financial, or tax advice.
With over eight years in public accounting, Marissa has worked closely with small business owners to navigate tax strategy and compliance. At Collective, she translates complex tax concepts for self-employed individuals into clear, practical content—supporting them on their tax journey so they feel informed, confident, and empowered to make decisions for their business.