If you work for yourself, operating as an S Corp instead of a sole proprietorship often makes more sense. Your business remains the same, but the tax benefits can be immense.
Why? Because with an S Corp, you can split your income between salary and tax-free distributions. The lower your salary, the less you pay in payroll taxes.
However, many S Corp shareholders struggle with determining a reasonable salary. Take too little, and the IRS will pounce; pay yourself too much, and you lose the tax savings you were angling for.
Read this guide to gain clarity on what constitutes a reasonable salary for S Corp shareholders.
Understanding the Requirement
The IRS mandates that S Corp shareholders who profit from their businesses must pay themselves a salary. This salary, also known as “reasonable compensation,” ensures that you’re appropriately taxed on earned income and prevents you from relying solely on distributions to minimize tax obligations.
However, the term “reasonable” leaves a lot of room for interpretation.
Factors to Consider
No one-size-fits-all answer to determining a reasonable salary for S Corp shareholders exists. The IRS considers various factors when evaluating whether a shareholder’s salary is appropriate, including:
The type of business you operate, your geographical location, and the size of your company should influence your salary. For example, a small-town business owner may receive a lower salary than their big-city counterpart due to cost-of-living differences.
Duties and responsibilities
Your workload and job responsibilities should be reflected in your salary. If you’re the owner and primary operator of the business, you can’t pay yourself like a secretary.
Think about your main tasks and find a corresponding position that matches. For example, if you spend 80% of your time building websites and 20% marketing your web development agency, your salary should reflect the average market rate for a web developer.
Experience and qualifications
Your education, experience, and skills also impact what is deemed a reasonable salary. If you have an advanced degree or specialized training, it’s expected that you’ll receive a higher salary than someone with less formal education or expertise.
Additionally, if your business requires particular certifications or licenses, the time and effort you put into obtaining them should be reflected in your salary.
A salary isn’t “reasonable” at all if you’re losing money. If your business isn’t making a profit, you don’t have to worry about your salary. There’s no “minimum” or “maximum” salary requirement for S Corp shareholders, as long as the amount you pay yourself makes sense compared to your company’s profits.
Since an S Corp shareholder’s salary is subject to payroll taxes, the amount you pay yourself should be proportionate to your work hours. For example, if you only work part-time in your business, paying a full-time salary wouldn’t make sense.
What Happens If Your S Corp Salary Is Too Low?
If the IRS determines that you’ve been paying yourself an unreasonably low salary, they may reclassify your distributions as wages and add payroll taxes and penalties. The agency uses various methods to identify potential cases of underpayment, such as comparing your salary to industry standards or analyzing financial data.
You could be fined such a large amount that your cash flow is affected.
What Happens If Your S Corp Salary Is Too High?
The IRS won’t care if your salary is too high, but you should. Your tax bill will swell if too much pay comes out as salary. One of the main reasons to form an S Corp in the first place is to avoid this heavy bill.
The S Corp 60/40 Rule
To avoid scrutiny from the IRS, many S Corp shareholders follow a “60/40 Rule.” This guideline proposes paying yourself 60% of company profits as salary and taking the remaining 40% as distributions. While this isn’t a law or regulation, it helps establish a reasonable balance between salary and distributions.
However, remember that the 60/40 rule is arbitrary and does not guarantee that your salary is considered reasonable. If the IRS deems otherwise, they can still reclassify your distributions as wages and assess taxes and penalties.
Seeking Professional Guidance
Given the complexities surrounding S Corp salaries, it’s wise to consult with a tax professional or accountant. Kondler & Associates, CPAs, specialize in tax planning and can help S Corp shareholders determine the correct salary.
Don’t leave your finances to chance—take advantage of our expertise and ensure that your business stays on good terms with the IRS. Schedule a consultation today.