What is a reasonable salary for an S corp? With Jamie Trull!

The 60/40 rule, as highlighted by RCReports, oversimplifies a complex issue and ignores many factors relevant to reasonable compensation. The business may become liable for additional employment taxes, and the owner may face penalties and interest on the unpaid taxes. It is important to note that the IRS can impose penalties of up to 100% of unpaid employment taxes, making compliance with reasonable compensation guidelines crucial. You might have heard of the 60/40 rule as a guideline for splitting earnings between salary and distributions. While it’s a standard benchmark some business owners use, it’s not an official standard.

Can an S Corporation owner choose to not take a salary?

Let’s look at two popular rules that claim an easy way to calculate S Corp salaries and why you should think twice before using them. Adds powerful capabilities on top of payroll, such as garnishment payment service, SUI management, background checks, and job posting through ZipRecruiter®1. These approaches are also used by the IRS, so to make sure they are accepted, the officer needs to have documentation on how it was calculated and include it in the corporate minutes. Feeling stressed about your business finances and not sure where to start? Use this FREE Bookkeeping for Veterinarians plug-and-play worksheet to learn how Creating a PROFFIT Plan™ can help you become more intentional with your profit and help you meet your personal and business goals.

• Luckily, there are several factors you can use to determine a reasonable salary.
• This documentation is crucial if the IRS ever questions your compensation.
• Remember, finding the right balance between salary and distributions is key to minimizing your tax liability while staying compliant with IRS regulations.
• These oversimplified approaches disregard the many factors determining reasonable compensation.
• Many states require unemployment recipients to be actively seeking work, and owning a business could hinder that qualification.

How the Rule Affects S Corp Owners

The IRS is on the lookout for S Corporations that fail to pay reasonable salaries to shareholders who perform services for the corporation. The failure to pay adequate salary- or no salary at all – to the shareholder-employee is a “Red Flag” for audit by the IRS. It’s important for an S Corporation to properly compensate working shareholders to avoid a big employment tax bill in the future along with interest and penalty.

• However, it’s up to the owner of the S corporation—the owner or the officers and directors—to decide how much to pay the employees for a salary.
• However, excessive or inadequate compensation may draw the attention of tax authorities.
• You should aim to pay yourself about 60% of your earnings as a salary while taking the remaining 40% as distributions.
• Ranks are limited to individuals, trusts, non-profits, and estates—they cannot have institutional investors.
• These penalties can be significant, sometimes reaching up to 100% of the unpaid taxes, plus additional negligence penalties.
• If you do your homework, have a reasonable basis for decision and show you made a good faith effort to pay reasonable shareholders salaries, the IRS is more likely to defer to your judgment.
• And for the self-employment income that is above $200,000 the owner pays 3.8% of taxes that include 2.9% for Medicare taxes and 0.9% for Obamacare taxes.

Examples of S Corp Salaries

• Consider your business’s unique situation to figure out a reasonable salary.
• The real issue is that these simplified rules fail to consider the many factors affecting reasonable compensation.
• The goal is to find the right balance between paying yourself enough to avoid unwanted attention from the IRS and avoiding overpaying and increasing your tax burden.
• While this can result in lower taxes in the short term, it can also raise red flags with the IRS if the salary portion is deemed unreasonably low.
• Alpine Mar emphasizes that freelancers who form S corporations must pay themselves a “reasonable salary” to avoid IRS penalties.
• Articles like this one on the S-Corp 60/40 Rule can offer further insights.

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. Unfortunately, such simplified rules have even been espoused by major firms and institutions due to their inability to properly define reasonable compensation for individual positions. They are providing advice that has the potential to put companies at risk of IRS audits or unnecessary payment of payroll taxes. An S corporation generally must have payroll to pay its employees and any shareholders who may be considered employees.

The IRS doesn’t set a fixed salary amount in stone, but instead, they look at industry standards and your business’s income to determine if you’re paying yourself fairly. Distributions from an S corporation to its shareholders are a different matter and are reported by the owners of a company that has taken profits above their salary. To report the owner’s distributions, they will use Schedule K-1 (Form 1120-S), which the shareholder uses to complete their personal tax return.

• By considering these factors collectively, you can arrive at a reasonable salary that aligns with industry standards and IRS requirements.
• This data offers a helpful starting point, especially if you’re unsure where to begin your research.
• Then, they must receive a reasonable salary for their work at the company.
• With the mindset of what’s gonna be IRS audit defensible and also what’s gonna make the most sense from a tax perspective, because we don’t wanna pay more taxes than we need to right now.
• And the other important thing I think that is critical to this conversation is to know that it’s not always just about setting the lowest defensible reasonable salary you can to save on taxes.
• Distributions are not considered employee wages and are not treated as self-employment income.

Alright, the 60/40 is busted, let’s take a look at another popular rule. By following these steps, self-employed S corporation owners can efficiently manage their salary and tax obligations, staying s corp payroll compliant with IRS rules and optimizing their tax efficiency. The IRS keeps a close eye on how S Corporations divide their profits across owners’ wages and salaries versus distributions and dividends because some unscrupulous people try to game the system. So if you choose S Corp election for your LLC or C Corporation, you must be careful about how much you pay yourself.

They have a whole proprietary system that pulls all this data, including by location. And I think it would be really difficult to actually explain to an IRS agent because that’s not usually how they’re gonna look at it, especially if you’re really running a small business. And again, that’s really only gonna be feasible and make sense if you don’t have access to this other data. As much as that seems easier to just say, okay, well I’m the CEO of my business, I’m gonna go look and see what I would pay a CEO.

Optimizing your S Corp compensation involves strategically balancing your salary and distributions to minimize tax liabilities while remaining compliant with IRS regulations. This requires a nuanced approach that goes beyond simple rules of thumb and considers your specific business circumstances. So let’s talk about what the IRS is gonna be income summary looking for, but we also wanna be setting our reasonable salary with tax savings in mind. But if you pay yourself, in addition, if you’re paying yourself owner’s draws above and beyond that reasonable salary, there is no self-employment tax being taken out on that.

Electing an S corp tax designation can provide tax advantages and tax savings for an LLC or corporation whose net income is enough to pay its member(s) a reasonable salary. S corps do require you to file additional forms at the end of the year and are subject to increased scrutiny from the IRS. S-corp business entities must pay wages to any shareholders who are corporate officers or perform more than minor services for the corporation. This ensures that shareholder-employees pay the same FICA and FUTA taxes that would be paid on their behalf if they worked for someone else, and helps to prevent tax avoidance.