It seems that some people still don’t realize that you need to have reasonable compensation as a “S-Corp” owner.
Definition and IRS Scrutiny
S Corporation owners who actively work in their business are required by the IRS to pay themselves a “reasonable salary.” This means the compensation must reflect what similar businesses would pay for comparable services under similar circumstances
. The IRS closely monitors S Corps to ensure owners are not underpaying themselves to avoid payroll taxes, and paying too little can lead to audits, reclassification of distributions as wages, and potential penalties
.
How to Determine Reasonable Compensation
Determining what qualifies as a reasonable salary can be challenging, especially for new businesses or those with fluctuating profits. The IRS provides no strict formula, but several factors are considered, including:
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The owner’s training and experience
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Duties and responsibilities within the company
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Time and effort devoted to the business
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What comparable businesses pay for similar roles
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The company’s dividend history
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Payments to non-shareholder employees
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Compensation agreements and industry standards
Many advisors suggest using salary surveys, the Bureau of Labor Statistics, or compensation analysis reports to benchmark appropriate pay
. Some informal rules of thumb exist, such as the 60/40 or 50/50 rules, where 40–60% of net profits are paid as salary and the remainder as distributions. However, these are only guidelines and not recognized IRS standards
. Ultimately, the salary must be justifiable based on the facts and circumstances of the business and the owner’s role.
Tax Implications and Compliance
Owner-employees must be paid through payroll, with appropriate federal and state income tax, Social Security, and Medicare withholdings. The S Corp must file payroll tax returns and issue a W-2 to the owner-employee
. Distributions beyond the reasonable salary are not subject to payroll taxes, which is a primary tax advantage of S Corps. However, if the IRS deems the salary unreasonably low, it can reclassify distributions as wages, resulting in back taxes and penalties
.
Summary
Setting a reasonable salary is essential for S Corp compliance and tax efficiency. Owners should document their rationale, use industry data, and review compensation regularly to avoid IRS scrutiny and maximize tax benefits
As opposed to the current, pray I don’t get audited…