What is a reasonable salary for an S corp?
S corporations represent 76.7% of all active corporate tax returns in the US. Small business owners find S corp tax status appealing because of significant tax benefits.
Unlike traditional corporations, S corporations do not pay income taxes. Instead, the company's profits and losses pass through to the owners' personal income tax returns.
S corporation owners need to pay themselves a fair salary for the work they do as employees in the business. It's essential to compensate oneself suitably to prevent possible tax inspections or fines.
In this article, we'll explore what qualifies as a "reasonable salary" and how to determine the appropriate one for yourself as an S corp owner.
What's the difference between salary and distributions?
Salary is the money you pay yourself as an employee of an S corporation. Distributions are the profits that pass through to you as an owner.
The salary is subject to payroll and income taxes, while the distributions are only subject to income tax. This is where you can potentially have significant tax savings if your taxes are set correctly.
The Internal Revenue Service (IRS) requires owners of S corporations to pay themselves a fair salary to avoid misuse of the system.
If you choose S corp status for your business, you must carefully consider how much you receive as a salary.
What is a reasonable pay?
A reasonable salary is the amount of money that similar businesses would pay for the same or similar roles and responsibilities.
The salary should not be too low, as it could raise a red flag for avoiding self-employment tax.
How to define a salary for an S corp owner and employee?
Several methods can help you determine your salary as an S corp owner and employee:
- Percentage of net business income: Determine your salary as a percentage of the company's net income. This method adjusts your salary based on the business's profitability.
- Percentage of gross revenue: This method is similar to the net income method but is based on gross revenue. It can be helpful for businesses with consistent revenue streams.
- Compensation analysis reports: Use resources like the Bureau of Labor Statistics, Glassdoor, Indeed, or LinkedIn to find salary information for your job and industry.
Pro tip. Business owners often fulfill multiple roles within their companies. The compensation should align with the primary role in which they invest most of their working hours. Regularly review and adjust your salary to account for changes in your job responsibilities or working conditions.
Other factors to consider when determining your reasonable salary:
- industry standards
- location and market conditions
- the company's financial health
- training and experience
- compensations for non-shareholder employees
- history taking distributions
Your company's payroll processes should determine the frequency of salary payments for you and your employees.
After determining an employee's compensation, keep copies of all the information used to make the salary decision. This will help you prepare in case the IRS requests confirmation.
What about the 60/40 rule?
One frequently recommended method for apportioning revenue between salary and distributions is to assign 60% to salary and 40% to distributions.
Another commonly cited approach proposes an equal split, with 50% allocated to salary and 50% to distributions.
The problem with both is that determining your salary without a clear basis may result in overpaying taxes or penalties for underpaying yourself. Always determine your salary based on your unique situation and circumstances.
How to pay yourself from an S corporation?
Salary and distributions
You must report your salary, including Social Security and Medicare (FICA) taxes, using IRS Form W-2. Report distributions on your personal income tax return using Schedule K-1.
Payroll
For payroll, you need to file federal quarterly payroll taxes using IRS Form 941. This form reports income and FICA taxes withheld from your salary. Additionally, you might need to file Form 1040-ES for estimated taxes on any additional income not subject to withholding. Note that you might also have state payroll tax obligations.
Annual tax filings
At the end of the year, prepare Form W-2 (Wage and Tax Statement) and Form W-3 (Transmittal of Wage and Tax Statements) for reporting wages, and Form 1120-S (U.S. Income Tax Return for an S Corporation) for the business's income, gains, losses, deductions, and credits.
If you need help with your S corp taxes, talk to a tax professional
Learn moreDisclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.