Understanding Reasonable Compensation & Your S-Corp

Chances are you decided to form an S-Corporation (S-Corp), named after Subchapter S of the Internal Revenue Code because you thought it would be fun. Of course, I joke. Most likely, you made the S-Corp election because you discovered it is an excellent way to avoid the 15.3% self-employment tax. There are, of course, other reasons but when it comes down to the numbers, NOT paying self-employment tax just makes sense, right?

As with anything tax related, there are rules and one of the biggest with an S-Corp is paying yourself (as an owner) a ‘Reasonable Compensation’. I hear you – this rule could not be any more ambiguous.

An S-Corp Owner must receive what the IRS deems a “reasonable salary” – essentially a paycheck that is comparable to what other employers would pay for similar services.

As a business owner, you choose how much to pay yourself. So, how much? Do your research and ask yourself these questions:

  • What can my business’ cash flow accommodate?
  • What do others in the same field get paid?
  • If you were previously employed in the same position, what was your salary then?
  • What are your duties and responsibilities?
  • How much time and effort are you devoting to your business?

The Bureau of Labor Statistics is an excellent resource that lists detailed salary information for more than 800 different occupations. Employer review sites such as Glassdoor and PayScale also offer compensation details for a wide variety of positions. You may even want to scan through job listings on Craigslist, Monster, or Indeed (keep in mind when reviewing job sites that not all information, such as insurance, bonus pay, or additional benefits, may be disclosed.

What if you do it all? Wear multiple hats, that is…

If you’re just getting started, it’s reasonable that you are CEO, VP of Sales, Customer Service Manager and Accounts Receivable Clerk. If it needs to get done, you’re the one doing it. You, of course, can figure out what percentage of your time is spent in each category, calculate the appropriate salary for each and come up with your reasonable compensation that way. However, if that feels a bit overly complicated (and we agree with you completely), look for the closest single role that aligns with your position within your company.

Documentation is key

Once you decide on your compensation, document it. How did you arrive at that number? If you researched sites like Glassdoor or PayScale, keep copies of the documentation you found and tuck it away with your corporate binder.

It’s our first year in business, is it safe to just take a distribution?

Another way to zero out your S-Corp at year-end it to take the profits (or a portion of) as a distribution. While this may be tempting, S-Corp owners who use this tactic may unknowingly become a target. If your S-Corp is at a loss or just breaking even, you are fine to not pay yourself a salary if NO distributions are made to avoid payroll taxes.

Think of it this way:

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. You don’t have to pay payroll taxes on distributions from your S-Corp.

Salary is the money you pay yourself, your employee wages or reasonable compensation, as an employee of the S-Corp. You have to pay payroll taxes on your salary, like any other employee.

Let’s say you are a mechanic with a brand-new shop. It’s new, so cash flow is all over the place. You are starting to see some consistency, but you made $60,000 per year at your last position and you’re not sure if you can yet afford to pay yourself that much. First, you’ll get there! Second, taking a smaller consistent salary is better than no salary at all. Unless you are living off loans or independently wealthy, you’ve got bills to pay. If you are not paying yourself something, you’ll find it too tempting to pull out money from your business account for personal reasons. Work with your accountant to determine a good place to start. In the long run, you’ll be glad you did.

What the IRS Hates

No matter what you hear, the IRS cannot require a business to pay its employees a minimum salary. What the IRS can object to is distributions made to avoid payroll taxes. So, if no payments (payroll or distributions) are made because your business is earning little or no income, that is acceptable. However, when the S-Corp begins to make money, reasonable compensation must be a top priority. Any remaining funds can then be considered for distributions.

Be Aware of State Laws

On a final note, be sure that you are aware of your state’s minimum wage law. The rules vary from state to state, all dependent upon where your S-Corporation is located. Although there is a federal minimum wage, 45 states have their own minimum wage laws. In California, for example, S-Corps should pay their owner-employees at least the minimum wage.

If you have any questions about this article or tax preparation, please contact us anytime.


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