So, you thought running an S-corporation was all about enjoying self-employment tax savings and easy-breezy distributions? Can we interest you in taking a second look at your salary, friend? There’s a good chance your salary could be too low – or even too high.
What does “reasonable compensation” even mean?
When we talk about “reasonable compensation” in the realm of S-corp taxation, we’re diving into a complex topic that generally involves a balance of both distributions and payroll.
The IRS is quite keen on ensuring that S-corp owners don’t just take distributions (which aren’t subject to self-employment taxes) and skip out on paying their fair share of Social Security and Medicare taxes through a salary. Hence, they require your compensation as an S-Corp owner to be, well, “reasonable,” meaning it should be comparable to what you’d pay someone else to do your job.
Why does a reasonable salary matter, anyway?
Getting your salary wrong could lead you straight into an IRS audit, and trust us, that’s a dance you’d rather sit out. A “reasonable compensation” ensures that you pay yourself (and other S-corp shareholder-employees) reasonably for the services provided to the business.
When you pay a reasonable salary, you’re also theoretically paying in the appropriate amount of employment taxes. If you don’t pay yourself a reasonable compensation, the IRS can reclassify some of your shareholder distributions as employee wages, and you’ll owe back FICA taxes (and probably interest and penalties) on that income.
But setting a reasonable salary goes beyond just staying in the IRS’s good graces. Your salary impacts:
- How much you contribute to Social Security, which affects your future benefits in retirement
- How much you can save for retirement if you use a plan that’s based on salary deferrals, such as a 401(k) or SEP-IRA
- Your potential unemployment benefits—many self-employed people who historically paid themselves a very low salary realized the potential downside when they claimed unemployment benefits (or applied for PPP) during the COVID-19 pandemic shutdowns, as their potential benefits were based on their wages.
So, what makes compensation reasonable?
The tricky thing is the IRS doesn’t give you a simple formula to determine reasonable compensation. (That would be too easy.)
According to IRS rules, “Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances.”
In plain English, that means the amount you pay yourself should be equivalent to what a similar business would pay someone to perform the same services.
Crunching the numbers: an example of how to determine reasonable compensation for an S-corporation
Let’s put theory into practice and walk through an example of how XYZ Design Studio, a small S-corp in the creative industry, calculates a reasonable salary for its owner, Alex.
Step 1: Identify the role and responsibilities
Alex is the Creative Director and founder, responsible for client management, project design, and overseeing a team of five.
Step 2: Industry and location benchmarking
Using industry reports and salary data for similar roles in their geographical location, XYZ Design Studio finds that a comparable salary for a Creative Director ranges from $75,000 to $120,000.
Step 3: Assessing the company’s financial health
XYZ Design Studio has had a good year, with net profits of $200,000. However, they also need to account for business expenses and future investments.
Step 4: Factoring in additional contributions
Alex has been instrumental in landing major clients and has worked beyond regular hours. Their contribution has directly impacted the company’s profitability.
Step 5: Determining the salary
Based on the data, XYZ Design Studio set Alex’s salary at $100,000, which is within the industry average but also reflects their significant contribution to the company’s success.
Step 6: Documenting S-corp reasonable compensation
To cover all bases, XYZ Design Studio documents the entire process, detailing why they believe $100,000 is a reasonable salary for Alex. They include the industry benchmarks, the company’s financials, and insights from a reasonable compensation study.
By following these steps, XYZ Design Studio ensures they’re not just pulling a number out of a hat but are making a well-informed and justified decision about Alex’s salary.
Don’t trust your gut (or the internet)
Now, we know it might be tempting to just go with your gut or take a quick peek at Salary.com or another generic salary guide floating around on the internet when determining reasonable compensation. But let’s be real—your income tax planning deserves more than a shot in the dark. That’s where our reasonable compensation reports come into play.
A reasonable compensation report is like having a GPS to help you navigate the labyrinth of determining a proper S-corp salary. It looks at the time you spend in the business, the services you perform, and what comparable businesses pay for that type of work.
You’ll have a tailored, data-driven analysis that takes into account your specific role, industry, and location, ensuring your S-corp compensation isn’t just “reasonable” but ready to withstand IRS scrutiny.
A reasonable compensation analysis isn’t just about setting a higher salary. In some cases, it can actually save money because it looks at everything a shareholder-employee does—all of the “unpaid labor” that goes into being a small business owner. We’ve seen several instances where “reasonable compensation” is less than the S-corp shareholder-employee would make if they got a job somewhere else because they’re not spending 100% of their time being a Creative Director (or other highly paid professional). They’re also handling admin, bookkeeping, marketing and sales, providing customer service, training the team, dealing with HR and IT issues, and more.
There’s no better time to give your reasonable comp a check-up
If it’s been a while since you determined reasonable compensation (or maybe didn’t put as much thought and effort into setting compensation as the task requires), it’s never too late to do a little salary soul-searching for your S-corp.
If you realize your salary is set too low, you can make any necessary wage adjustments and pay payroll taxes before you issue a W-2 or file your income tax return. It’s like a financial health check-up for your S-corp, ensuring everything is above board.Ensuring you pay reasonable compensation in your S-corp isn’t about playing a guessing game. It’s about making informed, strategic decisions that help you feel confident about the salary you’ve set. There’s no better time to take a closer look at your salary, and with our reasonable compensation reports, you’ve got the ultimate tool at your fingertips. So, reach out if you’re ready to set a salary that’s just right. Your S-corp (and your peace of mind) will thank you.