In this article we are going to talk about the reasonable compensation aspect of electing S Corporation status.
That is the $1,000 question. Unfortunately the IRS does not give us clear guidance in this area but they are able to point us in a direction at least.
The IRS states this:
- S Corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.
- The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation by looking to the source of the S corporation’s gross receipts.
- Services of shareholder
- Services of non-shareholder employees or
- Capital and equipment
- Some factors in determining reasonable compensation:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
As you can tell the IRS is not very clear as to what constitutes a reasonable salary but based on the information made available, along with court cases we studied, we have determined some optional methods for determining this reasonable salary.
Strategies To Determine S Corporation Owner Reasonable Salary
There is no magic bullet to determine a salary that the IRS will label as reasonable but here are two options we often discuss as starting points with clients.
- Option 1 – Easy Method but Harder to Defend: Use a percentage of net income prior to owner salary. This percentage should be at a minimum 30%, but can often range from 30%-50%+. Example: Net income prior to salary of $100k, using this method you would be in the $30k-$50k range for a reasonable salary, with closer to 50% being less risky.
- Option 2 – Harder Method but Easier to Defend:
- Determine the amount of hours you spend doing various tasks in your business, on a yearly basis: Your Specific Job (Lawyer, Marketer, Plumber), Administrative Duties, and Marketing Duties
- Find the rate someone doing those various tasks in your city and state gets paid (You can use BLS data from the government here).
- Multiply that rate by your yearly amount of hours worked.
- Add in any adjustments for special training, licenses, certifications, etc that you have.
- Add in any other special considerations (highly compensated, non owner employees, etc).
- Take all of that data and land at your final reasonable salary.
Option #1 is obviously easier to complete but the biggest downfall is you do not have any substantiation to back up your salary in the event of an audit. Option #2 take a little more leg work but in the event of an audit you have backup to support your determination of your salary. We have a calculator for Option #2 that you can reach out to us for if you would like a copy for yourself.
Note: Both options are simply starting points to figuring a reasonable salary. Each tax payer is different and you’ll want to sit down with a tax professional to really drill down to the salary that makes sense for you and your business.
What Happens If I Take Too Low Of A Salary?
The IRS has the authority to reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes).
- Basically in the event of an audit you would need to provide support that backs up the salary you took as a business owner.
- If the IRS determined your salary was too low, they would reclassify distributions you took into wages and you would need to pay back taxes, interest, penalties, and fees.
- Example: You take a reasonable salary of $50k but the IRS determines $80k is reasonable and you had distributions of $60k. The IRS would take $30k of your distributions and reclassify them as wages.
Note: If you took zero distributions in a specific year there would be nothing to reclassify. However if you took a distribution the next year the IRS would require you to pay the salary you should have taken in the prior year when you took no distributions.
How Do I Run Payroll To Myself?
We recommend a payroll software called Gusto for your payroll processing needs because they handle all tax payments and filings on your behalf.
If you need an introduction to our rep over at Gusto, contact us and we can invite you into the software!
When it comes to running payroll you have a few different options:
- Option 1: Setup a regular payroll schedule (weekly, bi-weekly, monthly, etc) and run payroll to yourself on a normal basis.
- Option 2: Take distributions as you need money and then at the end of each quarter run an off-cycle pay-run for your reasonable compensation amount. This will move a portion of distributions that you took into wages and you can then just pay the tax portion at that time.
- Option 3: If you elected a late election you will need to get caught up on payroll for the part of year already missed. In that case you can run an off-cycle pay-run for the tax portion and then move to Option 1 or 2 moving forward.
In our next article we are going to discuss “So I am an S Corporation, Now What?”.
If you don’t have a tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session.