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Reasonable Compensation for S-Corporations

Lana Dolyna, EA, CTC
Lana Dolyna, EA, CTC

Senior Tax Advisor

When a sole proprietor business becomes S-Corporation, one of the requirements from the IRS is to have the officer employee who provide more than services receive compensation. But how do we know what is the reasonable salary for an S Corporation officer? Does it need to be small or large? It is a choice that is in your hands and with our help, you will be able to choose what is right for you for the topic “Reasonable Compensation S-Corp”.

Table of Contents

How S-Corp Employee Pay Works

As a sole proprietor, in addition to income taxes, the owner must pay self-employment tax of 15.3% of net income of the first $137,700 which consist of 12.4% for social security and 2.9% for Medicare taxes. The net income of $137,700 is the maximum for the social security taxes, but the rest of the income is still subject to 2.9% Medicare taxes that has no limit. And for the self-employment income that is above $200,000 the owner pays 3.8% of taxes that include 2.9% for Medicare taxes and 0.9% for Obamacare taxes.

S-Corporation gives a choice to the owner on how much he will pay for self-employment taxes which can become great savings. As an active participant in the S-Corporation, the owner must receive compensation for the work he does as the IRS requirement, but it does not need to be all the net income earned from the business.

The compensation that the officer gets can be controlled by the officer himself if it is reasonable. And when the officer gets his salary, he still pays the payroll taxes from the amount that he receives of 6.2% for social security taxes and 1.45% for Medicare taxes and his S-Corporation pays 6.2% for Social Security taxes and 1.45% for Medicare taxes. The total payroll tax percentage paid is 15.3%, but the salary amount that is taxed can be much less than what he would be taxed as a sole proprietor if it can be proved to be reasonable.

S-Corp Reasonable Salary

The IRS requires officers-employees of the S-Corporation to receive compensation, but they did not give specific rules or formulas to figure out how much it should be. There are guides that the IRS is giving the business owners to follow, and this is the advantage that can help officers save on self-employment taxes. But the amount of the salary must be reasonable. The IRS is looking carefully at the tax returns and if they believe that the salary was not reasonable, they will audit the company.

Using Comparable Salaries for Reasonable Salary Calculation

IRS offers three main approaches on how to calculate salary for the officers. There is a market approach, an income approach, or the cost approach.

Market Approach

This approach compares your S-Corporation to other S-Corporations like yours. If a worker, not the owner of the company, does the same amount of work you do, how much would they be paid? This is one of the favorite approaches by the IRS, but this approach works better for the company that is well developed and the owner that participates in it has one job of managing the company. With the small companies that just changed from Sole Proprietor to S Corporation, the owner has to do so much more than just managing, so the IRS developed two more approaches to follow to help the owners decide on their reasonable salary.

Income Approach

This approach compares your S-Corporation to other S-Corporations like yours. If someone is not the owner of the company and does the same amount of work you do, how much would they be paid? This is one of the favorite approaches by the IRS, but this approach works better for the company that is well developed and the owner that participates in it has one job of managing the company. With the small companies that just changed from Sole Proprietor to S Corporation, the owner has to do so much more than just managing, so the IRS developed two more approaches to follow to help the owners decide on their reasonable salary.

Cost Approach

This approach breaks down the owner’s activities into jobs and responsibilities. The owner of the small corporation has a variety of the different jobs he performs in order to keep the business going. Sometimes he is being a manager, sometimes he is a construction worker, or a janitor. All these different jobs have different pay rate. Also, a big factor is the hours spent in each job and the experience in each job. To calculate the amount of reasonable salary, the owner needs to figure out the hours he does the different jobs and the payrate for each and all them all together.

Here is a simple example of how this can be calculated and documented. Let us say John has a construction company where he works with his workers. He has and experience of 3 years working in construction.  At the same time, he manages the business and does the marketing for it.

Jobs PerformedHours per weekPay rateTotal hours
Manager5$30$150
Marketing3$25$75
Construction worker20$20$400
Janitor2$13$26
    
Weekly Total30 $651

 

This table shows four different jobs and different pay rates for each. If John had to hire someone to do the jobs for him with the same kind of experience, he would pay them about the same. This is one of the more common approaches to figure out reasonable compensation for the owner.

These approaches are also used by the IRS, so to make sure they are accepted, the officer needs to have documentation on how it was calculated and include it in the corporate minutes.

One more addition to the salary is the Health Insurance and Pension. They can be provided by the S-Corporation and be included in the wages. But these benefits are not taxed for Social Security and Medicare. In the form W-2 these benefits are included in Box 1 as wages, but they are not included in Box 3 to be taxed for Social Security, nor they are included in Box 5 to be taxed for Medicare.

S-Corp No Salary First Year

When S-Corporation is still in the beginning stages, it takes some time before it becomes profitable. In this case the IRS will make an exception and the officers will not need to be paid if the company that have little or no income for the first year. This gives an extra year to the owner to avoid paying self-employment taxes. But when the company starts making money, the S-Corporation must pay the officers reasonable salary first.

S-Corp Salary 60/40 Rule

When the IRS started to require all officers that provide services to corporation receive wages, some accountants used 60/40 approach for paying salaries and distributions were 60% of the net income were advised to be paid as wages and 40% was advised to be paid as distribution.  But this rule is misleading because it was not approved by the IRS. The companies that followed this rule were audited and they had to correct their compensation by the IRS standards.

S-Corp Salary vs. Distribution

Salary

Distribution

Does an S-Corp Owner Have to Have Salary?

As one of the requirements from the IRS, the officer that performs services for the corporation must have reasonable compensation. Every year, the IRS goes through the corporation tax returns and if they see that the officers had small salaries, they are more likely to audit these companies to get the money they believe belongs to them. If the audit happens and IRS will prove that the salary was not reasonable, the S-Corporation will not only pay additional payroll and income taxes, but also will face high penalties. Then they will set the salary for you and you will be stuck with it.

If your S-Corporation has very little or no income at its beginning stage, the officers are not required to pay the salary. Once the company starts making money, it needs to pay the salary to the officers first.

The IRS has a list of factors to determine the reasonable compensation and what they look at when they decide if the officer has a reasonable compensation. This list comes from the Fact Sheet “Wage Compensation for S Corporation Officers”:

When you do figure out your reasonable salary, make sure you document it. If IRS ever decides to audit your company, you will have proof of why you believe your salary is reasonable. Do not let them set your salary, keep it in your control.

The Reasonable Compensation Takeaway

Having the information is the key to stay in control of your decision making and it will guide you in making the right decision on what your salary should be. If you become the S-Corporation owner, you can save on your payroll or self-employment taxes when you decide how much should you pay yourself. Make sure it is not too low, so it does not bring attention to IRS. Also, keep it under the maximum of the social security tax maximum of $137,700, otherwise there is no point of the reorganization of the company. When you are ready to make this move, we are here to help to guide you in this complicated process.