A Comprehensive S Corporation Salary Guide
In this comprehensive S Corporation Salary guide, we will talk you through determining a reasonable salary for an S Corp. We will explore the differences between S Corp distributions and pay, the IRS requirements for a reasonable wage, and various factors to consider when deciding on appropriate compensation. So let’s dive in! S Corp owners are required to be on payroll.
Running a business-of-one as an S Corporation (S Corp) can offer numerous tax advantages, including the ability to reduce self-employment tax liability and avoid double taxation at the shareholder level. By electing S Corp tax treatment, you can simplify your federal taxes and claim your business’s profits on your personal income tax return. However, to ensure compliance with the Internal Revenue Service (IRS) and make the most of these tax savings, it is crucial to understand how to pay yourself a reasonable salary as an S Corp owner and navigate the business structure effectively.
S Corp Distributions vs. Salary
Before delving into the details of determining a reasonable salary for an S Corp, it’s essential to understand the distinction between S Corp distributions and salary.
Distributions refer to the profits that pass through the S Corp to you as the owner or shareholder. These distributions are not considered employee wages, subject to payroll taxes, or treated as self-employment income.
Salary, on the other hand, is the money you pay yourself as an employee of the S Corp. It represents your employee wages or reasonable compensation and is subject to payroll taxes, including Medicare and Social Security.
Thinking about distributions as a Business-of-One might seem strange, but it’s important due to different tax rules. For an S Corp, you don’t pay payroll taxes on distributions. But your salary requires payroll taxes, like a regular employee. These taxes cover Medicare and Social Security, and they can grow quickly.
Taking income as distributions instead of salary saves you these taxes (15.3%). However, you must follow a rule: pay yourself a “reasonable salary” set by the IRS. The IRS demands a fair salary for S Corp shareholder-employees, similar to what others get. Trying to avoid taxes by wrongly calling your salary a distribution can lead to hefty penalties and back taxes if the IRS audits you. Fines can reach 100%, plus negligence fees. Each of these shareholders can receive distributions for their share of the company’s profits free from payroll taxes, as long as they’re receiving a reasonable salary for their work at the company. If a shareholder isn’t performing work for the company, they will not be an employee and instead would receive a K-1 for passive income.
What is “Reasonable Salary” for an S Corp Owner?
In the context of S Corporations, reasonable salary refers to the starting point for determining the amount an owner pays themselves as compensation for their services to the business. The IRS mandates that S Corp owners receive a reasonable wage, known as “business income,” to ensure they pay their fair share of payroll taxes, also known as self-employment taxes. This salary is subject to income tax, Social Security tax, and Medicare tax. It is important for S Corp owners to consider their particular situation and leverage third-party research to determine a reasonable salary, such as finding statistics about employee pay on the Bureau of Labor Statistics website, which provides detailed salary information for hundreds of jobs.
It is important to note that distributions representing profits and losses passed through the S Corp to the owner are separate from salary and payroll transactions. Distributions are subject only to income tax and not employment taxes. As an S Corp owner, distinguishing between salary and distributions, as well as the class of stock, is crucial for tax purposes. It is hard to earn distributions if you are the only employee or do not have other 1099 subcontractors.
If your business is a one man (or woman) band… the profit you generated is most likely wages because YOU did all the work to generate it. After the salaries and payroll transactions are paid, any remaining business profit may be passed through to the shareholders via distributions. However, it is important to note that an S corporation may not have more than 100 stockholders, and none may be nonresident aliens. Stockholders of an S corporation may also not be partnerships or corporations.
Determining a Reasonable Salary for an S Corp
Determining a reasonable salary for an S Corp owner involves considering several factors. While the IRS does not provide an explicit formula or guideline for calculating reasonable compensation, the following factors should be taken into account:
- Training and Experience: Consider your level of education, professional certifications, and specialized skills relevant to your role within the business.
- Duties and Responsibilities: Assess the scope of your responsibilities, including managerial tasks, decision-making authority, and day-to-day operations.
- Time and Effort Devoted to the Business: Evaluate the number of hours you dedicate to the business, considering both active and passive involvement.
- Dividend History: Examine the historical distribution of profits to shareholders and consider whether your salary aligns with this pattern.
- Payments to Non-Shareholder Employees: Compare the compensation of non-shareholder employees performing similar roles within the business.
- Timing and Manner of Paying Bonuses: Review any bonuses or incentives provided to key employees and assess their impact on determining a reasonable salary.
- What Comparable Businesses Pay for Similar Services: Research salary data for comparable positions in your industry, considering factors such as location, company size, and industry standards.
- Compensation Agreements: Consider any written agreements or contracts outlining compensation arrangements between the owner and the S Corp.
- Use of Formulas to Determine Compensation: Evaluate whether a formula-based approach, such as a percentage of revenue or net income, is appropriate for determining compensation.
By considering these factors collectively, you can arrive at a reasonable salary that aligns with industry standards and IRS requirements.
Researching Salary Statistics
Unsure where to begin? Use industry data to estimate your pay based on what others earn. You can gather salary insights from:
- Bureau of Labor Statistics: This free tool gives you a lot of info about salaries for about 800 jobs.
- Employer-Review Websites: Platforms like Glassdoor, Salary, and PayScale gather employee salary details by company, role, industry, and location through crowdsourcing.
- RCReports: You can buy a report designed for fair compensation analysis from this company.
What if you have multiple roles? Many small business owners juggle various responsibilities to keep their businesses running smoothly. For instance, a sole proprietor of a web development company might spend 75% of their time on web development and 25% on administrative and marketing tasks. These roles often have different pay rates.
Instead of calculating each role’s salary separately, look for a similar single role that closely matches what you spend the most time doing. This usually means focusing on the work you primarily engage in.
Adjusting your ideal salary as an S Corp
Finding the right salary is a good start, but it might not fit your business perfectly. Consider your business’s unique situation to figure out a reasonable salary.
For instance, you could lower the salary if:
- Your business makes less money than similar businesses nearby.
- You work part-time (less than 2,080 hours a year).
- Other factors, like buying items or hiring people, greatly impacted how well your business did.
When you’ve chosen your pay, make sure to write down how you decided on the amount. Keep the info you used to set your salary. This could be useful if you ever get audited.
The S Corp 60/40 Rule
You may come across the S Corp 60/40 rule or the S Corp Salary 50/50 rule when researching S Corp salaries. These rules suggest splitting revenue between salary and distributions, with percentages allocated to each category.
However, it’s important to note that relying solely on these rules may not pass IRS scrutiny. The IRS considers these arbitrary methods and may challenge the salary determined using these rules. It is best to calculate your reasonable compensation based on your unique circumstances and the factors discussed earlier.
Examples of S Corp Salaries
To provide a clearer picture of what an S Corp salary might look like, let’s consider a hypothetical example:
Athena is a freelance technical writer who operates an LLC taxed as an S Corp. She is her company’s sole shareholder and employee, generating $120,000 in annual profit. The Bureau of Labor Statistics states that the typical salary for technical writers is $78,590.
In this case, Athena’s company could pay her a salary of $78,000, reflecting market standards for her profession. She could also receive a $42,000 shareholder distribution, resulting in payroll tax savings compared to operating as a sole proprietorship.
It’s important to mention that until 2013, the IRS used to share yearly reports that had info about the average salary for S Corps. However, these reports should be used as rough benchmarks, not definitive guidelines for determining a reasonable salary.
Real-Life Examples
To emphasize the importance of paying attention to the reasonable salary requirement, let’s examine two real-life examples:
An accountant in Arkansas: This individual paid himself no salary but received $83,000 in distributions. If you owe $500 or more in taxes for money you earn by working for yourself, you must pay a part of that tax every three months during the year. As a result, the accountant faced back taxes and penalties.
- A CPA in Iowa: The CPA gave himself a salary of $24,000, but he got $220,000 from his company as the only owner. The IRS decided that his salary wasn’t fair, so they considered $175,000 of his money a salary that needed payroll tax.
These examples highlight the consequences of failing to pay a reasonable salary and the importance of complying with IRS guidelines.
How To Make Paying Yourself following S Corporation Rules
After you make your business official, like becoming an LLC, paying yourself becomes more than just taking money from clients. You have to act like a real business with workers, even if you’re only getting paid. Remember these points when you’re getting ready to set up your S Corp payroll:
- Organize as a legal entity: Set up your business as a legal entity, such as an LLC, to establish a clear distinction between your personal and business finances.
- Establish a payroll: Implement a payroll system to handle your salary payments. Even if you are the only employee, treating yourself as an employee helps ensure compliance.
- Payroll taxes: Your company is responsible for paying half of your payroll taxes, including Medicare and Social Security, from its funds. The remaining half is withheld from your salary and sent to the IRS as a tax payment.
- W-2 form: Your company must provide you with a W-2 form each year, reporting your total employee wages. This form is used to report your salary on your personal tax return.
- Unemployment taxes: Depending on your state’s requirements, your company may need to pay unemployment taxes on your behalf.
- Workers’ compensation coverage: Check your state’s requirements to determine if your company needs to provide workers’ compensation coverage.
- State disability insurance (SDI) payroll tax: Some states, such as California and New Jersey, require SDI payroll tax. If you’re the only company owner, you can choose not to participate in SDI in California.
It’s worth noting that managing these requirements and ensuring compliance can be complex. Many business owners opt to use payroll services or hire an accountant to handle payroll and tax obligations. Services like Gusto can simplify the process and ensure accurate compliance.
Reporting S Corp Salary and Distributions
Reporting your S Corp salary and distributions correctly is crucial to avoid any complications during tax season. Here’s what you need to know:
- Salary reporting: Your salary is reported on your tax return using the W-2 form provided by your company. When filing your tax return, include the total employee wages from your W-2 on your Form 1040.
- Distributions reporting: Instead of using a W-2, your S Corp uses IRS Form 1120S, known as the U.S. Income Tax Return for an S Corporation. This form tells about your company’s money you got and spent, how much you made, what you lost, and any tax benefits. It has a Schedule K-1 for each person who owns a piece of the company. This paper tells you how much money you gained or lost. You write down your share of the business’s money results from Schedule K-1 on your tax form.
It’s a good idea to ask a tax expert to fill out your company’s Form 1120S and Schedule K-1s. This helps make sure everything is right.
Taxation on Distributions
Although distributions are not subject to payroll taxes, they are considered personal income and are subject to federal income tax. If you owe $500 or more in taxes for your self-employed earnings, you need to pay estimated taxes every three months during the year.
To avoid underestimating or forgetting to pay quarterly taxes, you can increase the withholding from your employee salary to cover your tax obligations throughout the year.
Best Practices for Paying Yourself as an S Corp Owner
To ensure compliance with IRS regulations and mitigate the risks associated with noncompliance, follow these best practices for paying yourself a reasonable salary as an S Corp owner:
Conduct Market Research
Obtain salary data from reliable sources such as the Bureau of Labor Statistics, employer-review sites like Glassdoor, and compensation consultants. This study will help you understand how much people in your industry usually get paid for similar jobs. It will help you figure out a fair salary.
Document Your Decision-Making Process
Maintain thorough records of the factors you considered when determining your reasonable salary. This documentation will prove your compliance with IRS guidelines and support your decision if audited.
Use Professional Payroll Services
Consider outsourcing your payroll to professional services like Gusto or Paychex. These providers can handle the complexities of payroll processing, including tax withholding, reporting, and compliance, ensuring accurate and timely payment of your salary.
Establish a Regular Payroll Schedule
Determine a consistent schedule for paying yourself a salary. Whether monthly, biweekly, or quarterly, adhering to a regular payroll schedule demonstrates your commitment to fulfilling your employment obligations as an S Corp owner.
Separate Salary and Distributions
Maintain a clear distinction between your salary and distributions. Ensure that all compensation payments are correctly categorized and reported, reflecting the appropriate tax treatment for each.
Consult with an Accountant or Tax Professional
Seek guidance from an experienced accountant or tax professional who specializes in S Corp taxation. They can give you advice that’s just for you and your situation. This way, you follow IRS rules and save as much on taxes as possible.
By following these best practices, you can navigate the complexities of paying yourself a reasonable salary as an S Corp owner while minimizing non-compliance risks.
The Risks of Noncompliance and the Importance of Reasonable Compensation
Failing to comply with the IRS guidelines on reasonable compensation can have significant consequences for S Corp owners. The IRS closely scrutinizes the compensation practices of S Corps, and audits focusing on reasonable salary issues are not uncommon. If an audit reveals that an S Corp paid insufficient compensation to its owner, the IRS may reclassify distributions as wages subject to employment taxes.
The implications of such reclassification can be substantial. 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.
Conclusion
Determining the right salary for an S Corp requires careful consideration of IRS guidelines, industry standards, and your business’s unique circumstances. When you give yourself a fair salary, you follow tax rules and enjoy the tax benefits of being an S Corp. Remember to document your salary determination process and consult a tax professional if needed. Proper planning and adherence to IRS guidelines allow you to pay yourself what you deserve and focus on growing your business.
FAQs
What is an S Corporation Salary and how is it different from a regular salary?
An S Corporation Salary is the salary paid to an owner or shareholder of an S Corporation for their work in the business. It is different from a regular salary because it is subject to specific tax rules and regulations, including self-employment taxes and limitations on deductions.
How is an S Corporation Salary calculated?
An S Corporation Salary is calculated by determining a reasonable compensation for the services rendered by an employee of the S Corporation. Factors such as industry standards, job responsibilities, and market rates are taken into consideration to ensure that the salary is fair and justifiable.
Can an S Corporation owner choose to not take a salary?
No, S Corporation owners must pay themselves a reasonable salary. This is to ensure that the owner is being compensated for their work and to avoid potential tax issues. However, the owner can choose to take additional distributions in addition to their salary.
Are there any benefits or drawbacks to taking an S Corporation Salary compared to other types of compensation?
Yes, there are benefits and drawbacks to taking an S Corporation Salary. Some benefits include potential tax savings and the ability to contribute to retirement accounts. However, drawbacks may include increased administrative tasks and the need to pay yourself a reasonable salary as determined by the IRS.
Who pays more taxes, LLC or S Corp?
S Corporation shareholders often pay fewer taxes compared to LLC owners. S Corps allow for pass-through taxation, where profits are only taxed at the individual shareholder level. LLCs, on the other hand, may be subject to self-employment taxes in addition to income taxes.
