The reason many owners choose an S corporation is that distributions are not subject to self-employment tax the way sole proprietor profits are. The price of that benefit is paying yourself a real salary first. This article explains how the IRS thinks about it.
What the IRS requires
According to the IRS, an S corporation must pay a shareholder-employee reasonable compensation for services before making non-wage distributions. Payments the IRS considers reasonable compensation are treated as wages subject to employment taxes. There is no safe-harbor percentage or formula that works for every business.
The factors the IRS looks at
- 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.
The IRS also looks at where the corporation's gross receipts come from. Income generated by the owner's personal services points toward wages. Income generated by other employees or by capital and equipment can more reasonably support non-wage distributions.
How to build a defensible number
- 1List every role you perform: operations, sales, technical work, management.
- 2Estimate hours worked per week in each role.
- 3Research what a business would pay an employee to do that work in your area, using salary surveys, job postings, or compensation data.
- 4Consider your own experience and any specialized license or skill.
- 5Document the analysis in a short memo kept with your records.
- 6Pay the salary through payroll with regular withholding, and review it every year.
A simple illustration (hypothetical)
This example is only to show the mechanics, not a recommended salary. Suppose a one-owner business earns $120,000 of profit before owner pay. As a sole proprietor, self-employment tax is figured on 92.35% of net earnings: $120,000 × 0.9235 = $110,820, and 15.3% of that is about $16,956.
If, hypothetically, the owner of an S corporation is paid a reasonable salary of $60,000, payroll taxes are 15.3% of $60,000, which is $9,180, split between employer and employee halves. The remaining profit can be distributed without payroll tax. The difference of roughly $7,776 is the potential tax saving before added costs such as payroll processing, the extra S corporation return, and state taxes. Whether the salary is reasonable is a facts question that your accountant should support.
Risks of underpaying yourself
- The IRS can reclassify distributions as wages and assess back employment taxes, penalties, and interest.
- A very low salary can also reduce retirement plan contributions and affect benefits tied to wages.
- Lenders and mortgage underwriters look at W-2 income.
Other rules to remember
- A working owner is an employee and should receive a W-2.
- Health insurance for a more-than-2% shareholder has special reporting rules.
- Salary should be paid regularly through the year, not as a single year-end amount.
For the bigger picture, see LLC taxed as an S corp and LLC vs S corp. If you already have an S corporation and want your owner pay reviewed, our tax planning service can help, or you can schedule a business tax planning consultation. Outcomes vary and savings are never guaranteed.
