For S corporation (S corp) owners who are actively involved in their business operations, paying themselves a “reasonable salary” for the work performed is a requirement. The Internal Revenue Service (IRS) defines this reasonable compensation as an amount comparable to what other businesses in a similar industry and location would pay for equivalent services under comparable conditions. This required salary must be treated as standard wages, meaning it is subject to federal employment taxes (including Social Security, Medicare, and unemployment) and reported on the owner’s W-2 form.
Factors Influencing Reasonable Compensation
Neither the IRS nor the courts provide a rigid calculation or set percentage for determining reasonable compensation. Instead, they evaluate a range of factors to assess reasonableness, such as:
- The training, education, and professional background of the owner-employee.
- The specific duties and level of responsibility the owner handles.
- The amount of time and effort dedicated to the business activities.
- The compensation paid to other employees who are not shareholders.
- Salaries paid by comparable businesses for similar positions.
- Any existing compensation agreements.
- The use of established formulas or relevant industry data.
- The company’s history regarding dividends and bonus payments.
Addressing Common Misconceptions and Practical Advice
It’s important to dispel common myths; there is no IRS-endorsed “rule of thumb,” such as a 50/50 or 60/40 division between salary and distributions. A reasonable salary should not be arbitrarily determined as a percentage of business profits, nor should it be intentionally set low primarily to reduce payroll tax obligations.
Steps for Determining a Reasonable Salary
To arrive at a reasonable salary figure, S corp owners should conduct research into typical compensation levels for similar roles within their industry. Valuable resources include data from the Bureau of Labor Statistics or specialized industry salary surveys. Online calculators can also serve as a starting point by offering comparisons based on wages, distributions, and industry standards. Generally, if the S corp employs non-shareholder staff, the owner’s salary should be at least equivalent to, if not higher than, that of the most highly compensated employee who is not an owner.
Consequences of Failing to Comply
Should the IRS determine that an S corp owner’s salary was unreasonably low, they have the authority to reclassify distributions previously taken as wages. This can lead to significant financial repercussions, including demands for back taxes, along with applicable penalties and interest.
Overview Table: S-Corp Reasonable Compensation
| Aspect | Description |
| Definition | Salary comparable to market rates for similar services in similar firms. |
| IRS Factors | Experience, duties, time spent, industry pay, employee wages, agreements. |
| No Fixed Rule | Avoid arbitrary splits (like 50/50); base it on facts and industry data. |
| Tools | Utilize BLS data, industry surveys, or calculators for benchmarking. |
| Compliance | Salary must be reported as wages (W-2); improper splits risk IRS action. |
In Conclusion:
S corp owners must pay themselves a reasonable salary that aligns with industry benchmarks and reflects the specific responsibilities of their role. Maintaining thorough documentation and using comparative data are crucial steps to help substantiate the reasonableness of the salary if it is ever questioned by the IRS.