Reasonable salary for S corp owners

Why must S corp owners take a salary?

Distributions from an S corporation carry no payroll tax, while salary does. Without a salary requirement, owners could take all their pay as distributions and avoid Social Security and Medicare entirely. So the IRS requires shareholders who perform more than minor services for the company to receive reasonable compensation as wages before taking distributions. See when an S corp election saves tax.

What does the IRS look at?

The IRS and courts have used factors including:

• training and experience,
• duties and responsibilities,
• time and effort devoted to the business,
• what the company pays non-shareholder employees,
• timing and manner of bonuses to key people,
• what comparable businesses pay for similar services,
• any compensation agreements, and the company's distribution history.

The underlying question is simple: what would the business have to pay someone else to do the work you do?

How do you arrive at a figure?

1. List the roles you actually perform

   An owner of a small agency may be the account manager, the lead designer and the bookkeeper. Estimate the hours spent in each.

2. Find market pay for each role

   Use published wage data for your area and industry, job listings and salary surveys.

3. Weight by time spent

   Combine the market rates according to the share of your time in each role.

4. Check against the business's capacity

   A reasonable salary can be lower in a year the business genuinely cannot pay more, but the reason should be documented.

What about the 60/40 rule?

A common rule of thumb says pay 60% salary and 40% distributions. It has no basis in the tax code or IRS guidance. A consultant who generates all of the company's revenue personally may need a salary close to the profit, while a business with staff and capital doing most of the earning may justify a lower one.

What happens if the salary is too low?

The IRS can recharacterize distributions as wages, assessing the employer and employee payroll taxes that should have been paid, plus penalties and interest. Courts have upheld this. In a well-known 2012 appeals court case, an accountant who took a $24,000 salary while receiving far larger distributions from his firm had much of those distributions treated as wages.

A salary that is too high is not an IRS problem, but it gives up the payroll tax saving that made S status worthwhile.

What should you keep on file?

• A short note of your roles, hours and the market data used, updated each year.
• Board or member resolutions setting the salary, if the company keeps them.
• Payroll records showing the salary was actually paid through payroll during the year.
• How to set that payroll up is covered in S corp owner payroll.

How does salary affect the QBI deduction?

Salary paid to you reduces the business's qualified business income, so a higher salary can lower your QBI deduction, while for higher earners the wages paid can help lift the deduction's limit. See the QBI deduction explained.

This guide is general information. It is not tax or legal advice for your situation.