The gig economy is booming. According to McKinsey’s American Opportunity Survey, a remarkable 36% of employed people in the U.S. identify as independent workers.
Many are small business owners or freelancers with a single source of income. However, many hold full-time jobs while engaging in one or more side hustles. This aspect of the gig economy presents a unique challenge when determining responsible compensation.
What is reasonable compensation?
Reasonable compensation isn’t an issue for freelancers, independent contractors, or side hustlers operating as sole proprietorships or LLCs. These workers pay income and self-employment taxes on their share of the business profits regardless of how much they take out of the business in the form of draws.
But as their income grows, many gig workers change their business structure to an S–Corporation to reduce their taxes. In an S Corp, shareholders pay self-employment taxes—the self-employed version of Social Security and Medicare taxes—only on the salary they receive from the corporation. Because they only pay self-employment tax on their salary, this can result in tax savings under the right circumstances.
To prevent S-Corp shareholders from paying themselves too little salary, thus avoiding paying their share of Social Security and Medicare taxes, the IRS requires S Corp shareholders to pay themselves reasonable compensation.
Reasonable compensation is the value a business would ordinarily pay for those services under similar circumstances.
For example, say you own a marketing consulting business structured as an S Corp. Your net income from the business is $250,000. You might pay yourself a salary of $140,000 because that’s the average salary for a marketing director in your area. However, if you instead paid yourself just $25,000 to minimize taxes, the IRS would likely determine that’s an unreasonable salary. In that case, it would recast some of your earnings distributions into wages and seek to collect unpaid employment taxes.
The example above has been simplified for purposes of this article. In reality, it can be very difficult to calculate reasonable compensation without relying on a reasonable compensation report or study.
Reasonable compensation in the gig economy
Reasonable compensation is simple enough when you have one business—or at least one stream of income from freelancing. However, many workers today have a side hustle or two (or more) in addition to a full-time job. How does reasonable compensation work when you have multiple jobs?
Let’s say you have a full-time job as the marketing director, earning a salary of $140,000 per year. You also have a side hustle providing freelance marketing consulting services for three other companies. That business nets you an additional $140,000 per year for a combined income of $280,000.
What is reasonable compensation for the consulting business? Unfortunately, when determining reasonable compensation for an S corp shareholder, there is no single answer. Reasonable compensation is based on a variety of factors, including the number of hours worked, the complexity of the tasks completed, and the market rate for similar services.
Two questions to ask in this situation are:
- What would you have to pay to hire someone to replace you and perform the services and tasks you perform?
- If you were to close the business and go to work for a competitor performing the same services and tasks for the competitor that you currently perform for your business, what would the competitor pay you at fair market value for those services?
As for the second question, since you are performing those services for a local business for a salary of $140,000, that would seem like a reasonable compensation for your side hustle as well.
Fortunately, even if you set your salary from your side business at $140,000 per year, you won’t have to pay double the employment taxes.
That’s because you only pay Social Security taxes on your earnings up to the annual wage base, which is $160,200 for 2023.
When you have wages and self-employment earnings, the tax on your wages is paid first. So you’d pay Social Security (at a 6.2% rate) on 100% of your salary from your full-time job. But you’d only have to pay the Social Security portion of self-employment taxes on $20,200 of self-employment earnings.
There is no cap on Medicare taxes, so you’d pay that on 100% of your earnings from your job and self-employment.
All in all, determining reasonable compensation takes extra effort when you have a side hustle in addition to a full-time job. Being aware of the tax implications that come with side income is crucial for avoiding IRS scrutiny. If you need some guidance to understand what combination of wages and draw is best for your situation, check out our Reasonable Compensation Reports or please reach out! We’re happy to help you refine your reasonable compensation estimate.