An S Corp owner has to receive what the IRS deems a “reasonable salary”. Essentially this means that if you have a company that has made the S-Corp election, then you as an owner-employee have to receive a paycheck comparable to what other employers would pay for similar services. If there’s additional profit in the business, you can take those as distributions, which come with a lower tax bill i.e. big-time savings.
I discuss tax benefits of an S Corp in a separate post with some simplified examples.
Here, we’ll just focus on this mysterious “reasonable salary” requirement. To simplify this you must understand that there are two ways to earn income as an owner of an S Corp: (1) salary and (2) distributions. Salary is subject to payroll tax (15.3%). Distributions are subject to income tax but you don’t have to pay self-employment tax (15.3%) on distributions. In fact you don’t pay any tax on distributions if the distribution doesn’t exceed the tax basis. But ignore that lest sentence if it was confusing.
So as an owner of an S Corp the temptation is to take everything as a distribution because you’ll pay very little tax (just income tax, if any). For example, if your company, an S Corp, is making $100,000 you might be tempted to just pay that entire $100,000 to yourself as a distribution. In doing that you would avoid any payroll taxes or self-employment taxes and only be subject to income tax (if any). That means significant savings from a tax perspective.
Based on the above scenario, the IRS wants you to pay yourself a reasonable salary so that you aren’t paying everything to yourself as a distribution and avoiding taxes altogether. Surprise surprise, the government wants you to pay taxes. In fact, if you did pay yourself everything in the form of distributions and you were audited, the IRS might recategorize some or most of those distributions as salary and you’ll be subject to some substantial penalties.
But how do you figure out what a reasonable salary is exactly? Well, what do workers in your role get paid by similarly situated employers?
The IRS considers some of the following factors in determining whether you’re paying yourself a reasonable enough salary:
- 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.
- Use of a formula to determine compensation.
If you still don’t know the answer, you can also consult the Bureau of Labor Statistics which publishes detailed salary information for many occupations and professions.