Determining Salary and Distributions from Your S Corporation
Freelancers and small business owners can gain a significant tax advantage by electing S Corporation status. This allows owners to avoid the 15.3 percent self-employment tax. This comes with a catch: the Internal Revenue Code (federal tax law) requires S Corporation owners to pay themselves a “reasonable salary,” from which they must withhold income taxes and submit payroll (FICA and unemployment) taxes. This post discusses how the IRS defines a reasonable salary and how you can determine your own.
Determining a “reasonable salary”
An S Corporation must pay its owner-employees[^1] a “reasonable salary” in order to justify avoiding self-employment tax on distributions. What then defines a “reasonable salary”? As you might guess, the IRS has a complex set of fairly subjective criteria, including individual, company, and market factors.
The first set of criteria for determining a reasonable salary focuses on the individual owner-employee. This includes the following factors:
- Qualifications: Education, certifications and awards, and special training all increase an employee’s earning capacity. The same holds for an owner.
- Scope of work: Most freelancers and entrepreneurs hold the unenviable title of CEO: Chief Everything Officer. Aside from the crucial job of working on the business (a topic for future posts), you also work in the business, especially at the beginning. Ask yourself the following: if you needed to hire someone to do the work you do in the company, what salary would you offer and expect to be accepted by a qualified candidate?
- Prior years’ compensation: If you recently transitioned into owning your own business straight out of an employee position doing the same work, use your prior base salary as a good indicator here.
The second set for determining a reasonable salary focuses on your business. If you have recently started your business, you may not see much of a difference yet between the business’s finances and your personal finances; however, as your business changes and (hopefully) grows, you should adjust your compensation accordingly.
- Gross/net income: This focuses on the income statement. Companies with greater revenues (gross income) and bottom lines after expenses (net income) can afford greater salaries.
- Size: This focuses on the balance sheet. All else equal, larger companies—those with greater assets, liabilities, and equity—should pay more in total salary than smaller companies.
- Shareholder distributions: A key indicator, especially for a single-owner S Corporation, compares salary (subject to payroll taxes) to shareholder distributions of income (not subject to payroll taxes). If distributions greatly outweigh salary, or if distributions grow substantially over time while salary remains stagnant, the IRS may scrutinize your salary.
- Salary policy: As a new, small, or single-owner operation, you probably do not have a formal salary policy; however, if you have employees, management should develop a written policy including base salaries or wages, overtime and bonuses, benefits and other compensation, and promotion and raises. This policy should include both owner/management and non-management employees. This helps justify and ensure similar salary decisions for all employees. The goal here is to keep owners’ salaries up to par with employees’ salaries.
The final set for determining a reasonable salary focuses on market-level considerations. This includes both intra-industry comparison and general economic conditions.
- Market comparison: This criterion asks what someone doing your job earns as salary or wages across your industry. You can usually find this out with a little research (I would start by using Glassdoor).
- Economic conditions: In an economic downturn, such as the Great Recession starting in 2008, salaries flatten or even take a slight dip. Otherwise, salaries generally tend to rise, especially among top earners (those earning around or over $100,000 per year).
Given how the IRS defines a reasonable salary, how should an S Corporation compensate its owner-employees?
This remains a tricky, subjective game between the owner(s) and the IRS. You essentially have two mutually exclusive goals: maximize the (payroll tax-free) distribution while minimizing the risk of an audit due to insufficient salaried compensation.
You receive the benefit of S Corporation status by maximizing your distribution, which means minimizing your salary. S Corporations receive one more tax advantage over a sole proprietorship or partnership: the business, responsible for paying one-half of the payroll taxes, records the salary and its share of the payroll taxes as deductible expenses, reducing the taxable business income that passes through to the owners. Of course, that also means reducing the amount of cash available for the business to distribute to owners, but the tax savings generally make it worth it.
Earning a salary also helps the individual owner-employee at tax filing time. Income tax withheld from the salary throughout the year offsets the tax bill determined at filing. For those who have filed as a sole proprietor or partner with little or no withholding, the tax bill can come as quite a shock. Withholding helps offset this amount and reduce the shock.
Aside from these benefits, the first goal remains: maximize the distribution to minimize the FICA and unemployment taxes.
Minimize audit risk
Minimizing your salary increases the risk you will not meet the IRS criteria for a “reasonable salary” listed above, which can result in an audit and a new tax bill along with penalties, fees, and interest. Review the criteria above and estimate your salary as best you can. Feel free to contact your Personal CFO for help with this.
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[^1]: The IRS considers all corporate officers employees whom the business should compensate as such with reasonable salaries.