If you own an S-Corporation, you likely know that you need to pay yourself “reasonable compensation” for the job you perform for your company. But what happens if your S-Corporation cannot afford a reasonable salary?
What do you do then? In today’s post, I’ll answer some common questions and help you determine what to do in this situation.
First things first, if you’re not sure about how to determine reasonable compensation, I have a separate post that explains all of those details. Basically, the IRS requires that you pay yourself a “reasonable amount” to ensure that you’re not skirting taxes by only paying yourself distributions rather than wages that are subject to FICA taxes (Medicare and Social Security taxes).
To determine your reasonable compensation, you should use several defendable data points so that you don’t wind up in the IRS’ hot seat. The IRS is looking to see that your reasonable compensation is the “value that would ordinarily be paid for like services by like enterprises under like circumstances.”
What Happens if S-Corporation Cannot Afford Reasonable Salary?
So here’s the piece that causes confusion for many S-Corporation owners. Some owners take the right first step, which is calculating their reasonable compensation, and then when they get to the end of the year, they realize they cannot afford to pay themselves that amount.
If you find yourself in this situation, don’t panic. The IRS doesn’t require you to pay yourself your reasonable compensation amount if you cannot afford it. In fact, the IRS isn’t so much worried about the amount you pay yourself as they are worried about the amount you give yourself in distributions. This goes back to the whole idea of the IRS not wanting to lose out on your tax money. In fact, you can pay yourself $0 in wages as long as you pay yourself $0 in distributions as well.
Let’s look at some examples for my client, Emily. She owns a fiber arts S-Corporation where she weaves and sells beautiful, one-of-a-kind blankets and wall art. Emily worked with me to determine that her reasonable compensation should be $50,000 per year.
Example 1: In 2020, Emily’s company, like the rest of the world, took a huge hit in sales. At the end of 2020, Emily’s company had a net profit of only $30,000. Emily paid herself $30,000 in wages and $0 in distributions. She’s doing fine.
Example 2: In 2021, Emily’s company started to rebound, and the company had a net profit of $75,000. Emily paid herself $50,000 in wages and $25,000 in distributions. She’s doing great.
Example 3: In 2022, Emily’s company had to purchase new, pricey equipment and also hired an employee. Despite those additional costs, Emily’s company still pulled out a net profit of $110,000. Emily paid herself $50,000 in wages and $60,000 in distributions. She’s feeling fabulous!
From these examples, you can see that as long as Emily pays herself reasonable compensation first, then she’s good to go. You can also see that the distribution amount can be higher than the reasonable compensation amount without causing any problems. The only time Emily may have had an issue in these three years is if she had tried to pay herself any amount of distributions in 2020. This is because she wasn’t first able to pay herself reasonable compensation that year.
Loaning Your Business Money
Sometimes S-Corporation owners whose companies are struggling will begin transferring their personal money into their business accounts. If you’re going to do this, make sure that you do it right. You’ll need to follow the proper IRS and court guidelines for a loan which means being able to show proof of payment and also drawing up a promissory note that includes all of the correct information. Talk with a CPA if you need help with this.
If you follow the proper guidelines for making a loan to your S-Corporation, then when your company has enough net profit to pay back the loan, you can first repay the loan (not classified as wages or distributions) and then carry on with your normal reasonable compensation and distribution process.
If you don’t follow the proper guidelines for loaning personal money to your S-Corporation, then when you’re able to repay yourself for the loan, that money would actually be considered wages and would be taxed accordingly. If you accidentally repaid yourself in distributions prior to taking your reasonable compensation, then you could also be required to pay penalties and interest to the IRS.
Abridged by Amy
- The IRS cannot force you to pay yourself a certain amount of wages in any situation let alone if your S-Corporation cannot afford reasonable salary.
- When your S-Corporation is making enough money, then you must first pay yourself reasonable compensation before taking any distributions in order to avoid problems with the IRS.