There are a few things we need to talk about before we get to what is a reasonable salary?
S Corporation Tax Uniqueness
S Corporation (S Corp) is a special kind of tax status that owners of a corporation or a Limited Liability Company may elect to use. S Corporation status allows the business profits to be passed through to the owners (stockholders for corporations and members for LLCs). Because of this, all taxes on the profits are paid by the owner on their personal tax return.
It also allows the equity that the owner has in the company to be divided into different categories that are treated differently when taxed- draws, dividends, and salary. Personal and self-employment taxes are paid on salary, dividends are only taxed in personal and not self-employed
Salary is only available to the owners that are also managers (LLC) or officers (Corp) as this is considered an employee status.
How Does S Corp Employee/Owner Pay Work?
The IRS allows owners to wear two hats. That of a member/stockholder and a manager/officer. Managers and officers are considered employees of the business and therefore the pay they receive for their services is considered salary or wages.
S Corp Employee/Owner Must Be Paid a Reasonable Salary
The IRS has some rules about employees/owners under an S Corp status. First, the salary paid to the employee/owner must be reasonable. While this is a vague requirement, the best definition of reasonable salary is what would the business reasonably be expected to pay a non-owner to do the same job. This will vary with factors like the job done, location of the business, etc.
Second, the salary payments must be prior to any other distributions. Until the reasonable salary is met, all money paid is considered salary, not dividends or draws.
S Corp Must Withhold Taxes from Salary
Just like with any other employee, the business must withhold Federal income taxes and FICA (Social Security and Medicare) out of each salary payment. The business must also pay their share of the FICA taxes along with the other employment taxes, including unemployment tax and worker’s compensation.
It might be tempting to try to make the salary as small as possible and other distributions are large as possible, but the IRS is very strict on the reasonable salary rule. The IRS can come back and reclassify distributions to salary if they do not think you paid the employee/owner a reasonable salary, requiring the added amount to be taxed by FICA, and also add penalties on top for underpayment.
How to Figure a Reasonable Salary
To find a reasonable salary for an S corporation owner/employee, consider what the business would have to offer as a reasonable salary for any new employee who was not an owner in the area where the business resides. The IRS guidelines suggest you look at the following factors to determine reasonable salaries for your owner/employee:
- 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
- The use of a formula to determine compensation
Comparable Salaries
If the IRS comes asking how you decided on a reasonable salary, a comparison study is your best bet to stay on their good side. Do research into what you would have to pay to hire someone to do a comparable job. Also, do research into what other companies of similar size and location size had to pay for theirs.
Be Leery of Easy Formulas and Websites
There are several popular formulas that you might hear, but be leery of them. The 60/40 is probably the most known, where you pay salary at 60% and dividends at 40% of profits, but there are plenty of industries that reasonable is less than what standardized 60% yields, and others that 60% would not make a reasonable level. DO YOUR RESEARCH!
Two more popular ones are 50/50 and 33/33/33. Again 50% of profit as salary and 50% as dividends could be just as off the mark. 33% to expenses, 33% to salary, and 33% to dividends again is just wild guessing. Again, DO YOUR RESEARCH.
Also, be leery of Website numbers, you don’t know how much research went into them and they often give national or state averages, not location averages. Check your state’s Secretary of State website to see if there are any official statistics, maybe a link to the SBA site with those statistics.
Ask other business owners, networking is going to help you in so many ways and this can be a good way to start a networking relationship with others.
Deducting Officer Salaries as a Business Expense
Wages of employees are tax-deductible expenses, including wages paid as a salary to an employee/owner. Any premiums paid to insurances as part of employee packages are also tax-deductible.
Dividends and draws paid to the owner are not deductible though.