S-Corp Reasonable Compensation

What Is Reasonable Compensation for an S-Corp Owner?

Electing to be taxed as an S-corp offers significant savings on self-employment tax as well as several other financial benefits, but S-corps must pay their owner/officers a reasonable salary. The term reasonable is highly subjective, and contrary to popular belief, there’s no set formula or process for determining a reasonable salary. 

To prevent taxpayers from evading tax by claiming excessively low S-corp salaries, the IRS is increasing audits of S-corp returns. If you’re facing an audit or need guidance on how to make your S-corp audit-proof, contact us at the W Tax Group today.

Do S Corporation Owners Have to Take a Salary?

If an S-corp owner provides services for the company, they must take a salary. The salary should be reasonable based on the work done, the time spent working, and the owner’s experience. 

The owners of an S-corp are referred to as shareholders. If the owner/shareholder is also involved in the company’s daily operations, they may be considered an officer of the company. Officers must take salaries, but shareholders who are not involved in the business’s daily operations do not need to take a salary. 

Although S-corps can have up to 100 owners, many of these businesses have a single owner who works in the company. 

Taxation on S-Corp Wages and Dividends

Shareholders of S-corps receive distributions based on the company’s profits. That means if someone is an officer of an S-corp, they may receive both wages and dividends, and the IRS taxes these payments differently. Wages are subject to payroll tax and income tax, while distributions are only subject to income tax. 

Here’s a quick example of how this works for an S-corp with a single owner/officer:

• Imagine the S-corp has $100,000 in net profits before accounting for the officer’s wages. 
• The officer receives a $60,000 salary, and they pay Social Security tax, Medicare contributions, and income tax on those wages. 
• The S-corp pays the employer’s portion of payroll taxes on the wages which is $4590. 
• The remaining profits of $35,410 are considered to be a corporate dividend to the owner and only subject to income tax. 

If this sole proprietor had not elected to be taxed as an S-corp, they would have faced self-employment tax and income tax on the full $100,000 generated by the company. In this case, electing to be taxed as an S-corp saves them approximately $6120. 

However, if this same solopreneur drops their wages down to $20,000 per year, they save $12,240 in payroll taxes. 

From a taxpayer’s perspective, the best option is to have the lowest salary possible, but of course, the IRS wants to receive as much tax as possible. Many cases have gone to Tax Court over these conflicting priorities, and although taxpayers have prevailed in some cases, the IRS wins many S-corp compensation cases. To protect yourself, you need a salary that is reasonable. 

Reporting Income From S-Corps

S-corps file a standalone tax return on Form 1120-S. The tax return claims deductions for wages paid to officers and for the company’s portion of payroll taxes. Officers receive a W2 form showing the wages they’ve received throughout the year. The 1120-S also shows the profit the S-corp made during the year, and this amount flows to shareholders as dividends which are reported on a K-1 form. 

To return to the above example, the officer/owner would receive a W2 showing $60,000 in wages. They would also receive a K-1 showing $35,410 in dividends. Again, the W2 wages are subject to payroll and income taxes, while the K-1 dividends are only subject to income tax.

What Is Reasonable Compensation?

The IRS looks at multiple factors to determine whether or not a salary is reasonable, including the following:

• Duties and responsibilities.
• Time spent working in the business. 
• Training and experience. 
• Payments to non-shareholder employees.
• The market rate for similar services. 
• Dividend history.
• Timing and manner of payments to key people. 

In all cases, the officer’s wages should not exceed the money they received from the company. To illustrate, let’s say that a restaurant with two owners elects to be taxed as an S-corp. The owners are both very involved in the business as a chef and a manager. If they worked for another company, they would likely get paid at least $50,000 per year each. 

However, the business only has $20,000 in profits, and the two owners split equally. In this situation, the officers do not need to report any more than $10,000 in wages each. 

Ideally, however, you want to be in a situation where the business generates enough profit so that the officers can have both a salary and dividends. If this same restaurant earned $150,000 in profits, it could likely pay each of the officers $50,000 in wages and the remaining amount as dividends. 

How to Calculate Reasonable Compensation

Despite popular misconceptions, there is no set formula for determining reasonable S-corp compensation. However, there are a few methods you may want to consider when trying to determine reasonable compensation. 

• Cost approach: How much would it cost to replace the shareholder’s role in the company? If you hired a third party for the same job, how much would you need to pay them? 
• Market approach: What salary does the market dictate? If you did the same work for another company, how much would they likely pay you?
• Income approach: How does the salary compare to the company’s overall profits? 

The income approach can be tricky. Some people claim that your income should be at least 50 to 65% of the company’s profits, but the IRS doesn’t use metrics like this. Instead, the matter is subjective. For example, with some roles, the agency may consider a $50,000 salary from an S-corp that has $100,000 in profit to be reasonable, but when looking at another professional, the agency may consider an $80,000 salary to be more appropriate with the same amount of profit. Again, it boils down to the other factors noted above.

Consequences of Not Taking Reasonable Compensation

If you are audited and you don’t pay yourself a reasonable compensation, the IRS may decide to reclassify your distributions as wages, and that will lead to additional tax. Not reporting a reasonable compensation can also heighten your risk of having your return audited. 

To explain how the tax works, imagine that you paid yourself $20,000 as a salary and you received $80,000 in dividends from your S-corp. The IRS selects your return for audit. They determine that your salary was much too low and that it should have been $70,000.

That means that they need to reclassify $50,000 of dividends as income. Now, you will face self-employment tax on that income at a rate of 15.3%. Technically, the company will pay half and you will pay the other half, but as you’re the only owner, all of the money comes out of your pocket. 

You may also face penalties. The IRS can assess a variety of penalties for failing an audit, and they range from a few percentage points of the unpaid tax up to 75% of the unpaid tax in fraud cases. You may also face payroll penalties.

Importance of Documenting Reasonable Compensation Determination

Reporting a reasonable compensation on your S-corp returns helps to protect you from being audited, but if you are selected for an audit, you should have documentation showing how you determined your salary. That will improve your chances of getting through the audit successfully without having your income reclassified. 

You may want to write a narrative description of how you determined your compensation, but you may also want to include supporting documentation such as pay scales or job advertisements for similar roles in your industry.

FAQs on S-Corp Compensation

Why can’t I take profits instead of wages from my S-corp?

The tax code says that S-corp officers who provide substantial services must pay themselves a reasonable salary. If you only take dividends or benefits from the company, the IRS may reclassify those amounts as wages and assess interest and penalties accordingly. 

What is the 60/40 rule?

The 60/40 rule says that S-corp officers should have compensation that ranges from 40 to 60% of the S-corp’s profits. This concept can be a good starting place, but ultimately, the IRS does not use these numbers when determining reasonable compensation. Depending on the specifics of the situation, the IRS may expect you to pay a higher or lower percentage of the company’s profits as your wages. 

How often should I pay myself?

Payment schedules vary, and you can choose a schedule that works best for your business. Some S-corp owners put themselves on a weekly or bi-monthly payment schedule. Others pay themselves quarterly or even annually. 

How should I pay my S-corp salary?

To pay yourself, you can simply cut a check or transfer funds to yourself from the S-corp’s account. However, you also have to ensure that you report the payment on IRS Form 941 or 940 and deposit the payroll taxes accordingly. 

Do you have to pay yourself for distributions from your S-corp?

If the S-corp has profits after paying officer wages and other expenses, the profits must be reported to the shareholder(s) on a K-1. Then, the K-1 income must be reported on the shareholder’s personal income tax return(s). Even if the profits stay in the company bank account and don’t get distributed to the shareholder(s), they must report and pay tax on that income.

Should you contact a tax attorney?

If you are facing an audit, you should reach out to a tax attorney for help. They can represent you through the process and help create an argument that your wages are reasonable. A tax attorney can also help you determine reasonable wages, explore the other benefits of S-corps, and help you with business tax planning. 

Ultimately, you want to pay yourself a salary that optimizes the tax benefits of your S-corp, without being too low for the IRS’s auditors. We can help you strike the right balance.

At the W Tax Group, we represent clients nationwide who are having trouble with individual or business taxes. If you want audit representation, help with tax planning, guidance on reasonable compensation, or help with other tax problems, contact us today. We leverage our vast experience in the tax field to find customized, sustainable solutions for our clients.