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Startup Basics: Books, Workers and S Corporation Pay
A new company sets habits in its first year: which accounting method it adopts, what records it keeps, how it classifies its first workers and how it pays its founders. Here are seven rules in brief.
Cash, accrual or modified cash
Your method decides the year income and expenses count. You adopt it on your first return, and a change usually needs IRS approval on Form 3115. Individuals, S corporations and partnerships with only individual partners may use the cash method. C corporations and partnerships with a C corporation partner need average gross receipts of $32 million or less (2026). For tax, "modified cash" is a hybrid method that must clearly reflect income and be used consistently. Read the full page.
Books and records
Your records must clearly show your income, deductions and credits, and you must be able to support them. The law does not require a specific format. Keep most tax records 3 years, 6 years if you left out more than 25% of income, 7 years for bad debts and worthless securities, and payroll records at least 4 years. Electronic storage must meet IRS requirements before you shred paper. Read the full page.
Employees vs contractors
The IRS looks at behavioral control, financial control and the type of relationship. A contract label does not decide. Employees need Form W-4, withholding, Forms 941 and 940 and a Form W-2. Contractors need a Form W-9 and, at $2,000 or more in 2026, a Form 1099-NEC. Backup withholding is 24% when a payee has no taxpayer ID. Illinois unemployment insurance uses a stricter three-part test. Read the full page.
Accruing expenses at year-end
On the accrual method an expense is deductible when the all-events test and economic performance are met. Bonuses and vested vacation pay can be deducted for the year earned if paid within 2½ months after year-end. Amounts owed to a person who owns any S corporation stock are deductible only when paid, so pay owner bonuses by December 31. Read the full page.
S corporation owner pay
An officer who performs services is an employee. The S corporation must pay reasonable compensation through payroll before it makes distributions. There is no fixed percentage: the IRS and courts look at duties, time, training, comparable pay and other factors. Write down how you set the salary. Read the full page.
2% shareholder rules
An S corporation shareholder who owns more than 2% on any day of the year (counting some family stock) is treated like a partner for fringe benefits. Many benefits become taxable wages in Box 1 of the W-2, and the shareholder cannot join a cafeteria plan, FSA, HRA or QSEHRA or make pre-tax salary-reduction HSA contributions. Read the full page.
S corporation owner health insurance
The S corporation must pay the premiums, or reimburse the owner, in the same year, and report them as wages in Box 1 of the W-2 (not Boxes 3 and 5). The owner then deducts them on Schedule 1, line 17, within the earned income limit and only for months without access to a subsidized plan. Read the full page.
For founders and early-stage companies
- Your accounting method is chosen on your first tax return. Think about investors and lenders, who may want accrual statements.
- Early hires and freelancers are where misclassification starts. Use the IRS test, not the label in the contract.
- Founders who work in an S corporation need a documented, reasonable salary through payroll, and a correct W-2 for health insurance.
Every topic has a full page, with tables, examples and the IRS sources, in the Small business compliance guide on SmallTax.com.
Official sources
- IRS Publication 538: Accounting periods and methods
- IRS Publication 583: Starting a business and keeping records
- IRS: Independent contractor (self-employed) or employee?
- IRS: S corporation compensation and medical insurance issues
- IRS Publication 15-B (2026): Employer's tax guide to fringe benefits
- IRS: Instructions for Form 1120-S
This article is general education, not tax, legal or investment advice. Thresholds, limits and deadlines change; the figures above are for 2026 and were checked against the IRS sources listed on October 21, 2026. Verify current figures with the IRS or a qualified tax professional before acting.