There are so many important questions to answer when running your own business. One of the most important questions S Corporation business owners answer each year is how much to pay themselves.
In today’s article, I’ll fully explain reasonable compensation for S Corporations: what it is, why it’s important, and how to do it right.
What is reasonable compensation for S Corporations?
As you likely know, one of the biggest advantages of owning an S Corporation is pass-through taxation. Because of this, tax savings for you and your company are at their peak when you can reduce the amount of payroll taxes (Social Security and Medicare) you and your company pay. The way to do this is to pay yourself as little as possible in wages, but that could get you into hot water with the IRS. Instead, the IRS requires that you pay yourself “reasonable compensation” for the job(s) you perform.
How does the IRS suggest I determine reasonable compensation?
It would be easy to figure out an amount for reasonable compensation if the IRS just told you how much to pay for certain jobs, right? Unfortunately, that sort of chart doesn’t exist. Instead, in an IRS Fact Sheet, they provide a list of 9 factors that the courts (and you) can use to help determine reasonable compensation:
- 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
- The use of a formula to determine compensation
Additionally, the IRS takes into account the type of business you have when determining compensation. For instance, if your S Corporation generates most of its revenue through personal services that you or other shareholders provide, then it would expect that cash payments for those services be categorized as wages. If, however, your business requires that you use lots of equipment to get the job done, then the money paid to use the equipment (to shareholders owning that equipment) would not necessarily need to be categorized as wages.
How can I calculate reasonable compensation for my S Corporation?
It’s very likely that after reading the IRS guidance you’re still feeling confused about how much to pay yourself in wages. Fortunately, there are tools and advice to inform your decision. To help you sort through this information (and sometimes misinformation), I have outlined the most common tools and advice with notes about why you may or may not want to use each:
This tool takes the guesswork out of determining compensation. You will complete a survey that takes into account all factors the IRS suggests you use as well as other geographic and database information. Then, you will be provided with a downloadable PDF report that you can use immediately to determine wages. This report will be invaluable to you if ever you need to defend yourself against an IRS challenge regarding reasonable compensation. This is the tool that I highly recommend to all of my clients.
60% Wages and 40% Distributions
This is a rule that many accountants suggest to clients. The idea is that an S Corporation’s profit should be divided between wages and distributions with 60% of profits categorized and distributed as wages and 40% of profits categorized and distributed as profits. Sometimes this works, but sometimes it doesn’t, especially when a company is just starting out. The main problem is that 60% of profits may not be equal to a “reasonable compensation” and would be hard to defend against an IRS challenge.
Tax Return Data
Many accountants and business owners have used IRS tax return data to determine the average salary of other S Corporation owners in their industries. Although this may be a good starting point for determining your salary, remember that using an average from across the nation may not reflect what you could or should be paid for your job, in your industry, in your area.
Similar to using tax return data, many small business owners search popular job-related sites such as LinkedIn, Monster, and Salary to find a reasonable salary amount for themselves. As long as you have the time and energy to comb through these sites, this may be a good place to start. Just like when using tax return data, however, remember that averages don’t always reflect your personal circumstances.
Wage Base Limit
The IRS sets a yearly wage base limit for social security taxes. For 2020, the wage base limit is $137,700. This means that social security taxes will only be taken out on income up to that amount. For this reason, many think it’s reasonable for an S Corporation to pay this amount in shareholder wages. This rule of thumb does reportedly work well for those whose company profits are higher than this amount. However, setting an employee’s wage based upon a wage base limit for everyone in the nation isn’t taking into account any of the guidelines given by the IRS to calculate reasonable compensation and this would be difficult to use as evidence in defending against an IRS challenge.
Similar to the wage base limit amount, many accountants have encouraged their clients to pay themselves $100,000 of profits in wages and then the rest of profits in distributions. Again, akin to some of the other methods used, arbitrarily making a salary of $100,000 doesn’t take into account any other factors that could easily be used to make a better determination.
As you can see, there’s quite a bit of consideration that needs to go into determining reasonable compensation for an S Corporation. If you’re feeling overwhelmed or need more specific advice, don’t be afraid to contact a CPA or use the tool I recommend to my clients when going through this process. Once you’ve set your salary, if you need help figuring out how to pay yourself, I can walk you through that as well.
Even though determining reasonable compensation is an important decision, this is definitely something you can do on your own with the right knowledge and tools. After all, paying yourself for your hard work is supposed to be the fun part, right?