A Business owned by one person (or more persons) often elects to be treated as an S Corp instead of a sole proprietorship or a partnership for tax purposes, because of the sweet tax savings you can reap from the status.
But, to stay above board with the IRS while making the most of those tax savings, you have to be careful about exactly how you pay yourself as an S Corp.
An S Corp owner has to receive what the IRS deems a “reasonable salary” — basically, a paycheck comparable to what other employers would pay for similar services. If there’s additional profit in the business, you can take those as distributions, which come with a lower tax bill.
Like anything involving taxes in the U.S., it’s complicated. So here’s a simple-as-it-gets guide to paying yourself a reasonable salary in an S Corp.
S Corp distributions vs. Salary
For tax purposes, you can elect S Corp tax treatment to keep your taxes (relatively) simple and claim the profits on your personal tax return, instead of paying corporate taxes.
In accounting terms, you earn money two ways when you own a business:
Distributions are the profits (and losses) that pass through the S Corp to you as an owner (shareholder). Distributions are not your employee wages and are not treated as self-employment income.
Salary is the money you pay yourself as an employee of the S Corp — your employee wages or reasonable compensation.
It’s a little odd to think about distributions as a Business owned by one, because the business’s profits are generally all your income. But you distinguish how you receive that income, because they have different tax implications.
You don’t have to pay payroll taxes on distributions from your S Corp.
You have to pay payroll taxes on your salary, like any other employee.
Payroll taxes are a 15.3% tax on income that covers Medicare and Social Security (separate from your income tax). It can add up fast! So any income you take as distributions rather than salary saves you that cost in taxes.
To curb the obvious temptation to take all your gross receipts as distributions rather than salary, the IRS sets a basic guideline: You have to pay yourself a “reasonable salary.”
A reasonable salary is a must
The IRS requires S Corp shareholder-employees to receive a reasonable employee salary, which it generally defines as at least what other businesses pay for similar services. Evading taxes by disguising your salary as a distribution could get you serious penalties, on top of a big back-tax bill, if an IRS audit recharacterizes your S corporation income as salary. You could pay tax penalties of up to 100%, plus negligence penalties.
What is a reasonable salary for an S Corp?
It’s up to you to decide how much employee salary to pay yourself versus how much to take as distributions. Which might sound exciting, except you have to make sure it jives with the IRS rules. Let’s take a look at how to determine a reasonable salary for an S Corp.
Here’s a general rule to follow for an S Corp reasonable salary: Reasonable pay is the amount that similar enterprises would pay for the same, or similar, services. What do workers in your role tend to get paid under an employer? Or, if you were employed in a similar role before, what was your salary as an employee?
The rule isn’t spelled out explicitly in tax law anywhere; instead, the vague guideline has been interpreted through court cases. That adds some extra fun to your compliance effort!
Here are some of the factors the IRS considers to determine whether you’re paying yourself an S Corp reasonable salary:
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.
Use of a formula to determine compensation.
Note: The S Corp “reasonable salary” requirement only comes into play if you (and other shareholders) take distributions from the company’s profits. The IRS can’t impose a minimum salary requirement, so don’t fret if your business isn’t earning enough yet to pay yourself a salary comparable to others in your field.
At P3 Accounting, we work with our clients on a regular basis to help keep them compliant in all realms of accounting and taxation!