How Much Should My S-Corp Pay Me?

First up, let’s address the big picture. As you may have learned in What is an S-Corporation?, the biggest incentive for making the S-Corp election is the potential savings on your small business taxes. These tax advantages are due to the pass-through income structure of S-Corps where income is paid to shareholders in the form of ‘distributions’ (or dividends), and distributions are not subject to Social Security or Medicare tax, which is currently a combined 15.3% self-employment tax rate. Voila! A whopping 15.3% saved on small business taxes!

The caveat to this structure is our current topic: any employee who is also a shareholder in the S-Corp must be paid what the IRS calls, “reasonable compensation,” before receiving distributions, and it applies to single-owner S-Corps as well as S-Corps with multiple shareholder-employees. The IRS enforces this rule to prevent small business owners from claiming all income as distributions and thus avoiding Social Security and Medicare taxes all together.

“Reasonable Compensation” is one of the most important factors in an S-Corp, but the subject is often shrouded in mystery and confusion for small business owners. What is it? How do I determine it? Who is checking? And unfortunately, the IRS doesn’t provide a whole lot of clear-cut guidance. Luckily, we’re here to fill in the gaps and help S-Corp small business owners navigate reasonable compensation and any other puzzling S-Corp topics. Prefer to have personal advice from a professional bookkeeper specializing in small business taxes and S-Corp accounting? Give our CPA Firm a call!

What is Reasonable Compensation?

As you’ve likely gathered already, “reasonable compensation” isn’t a particularly concise topic, but here at s-corp.biz, we’re all about simplifying. We’ll break it down below, but first, the simple answer to your question “What is reasonable compensation?”

Reasonable compensation is the salary amount, subject to Social Security and Medicare tax, that all S-Corp employees who are also shareholders must determine and be paid before they can receive the distributions that are not subject to such taxes.

Why Does Reasonable Compensation for S-Corps Matter?

S-Corp status can be super advantageous for small business tax savings, which is why you don’t want to risk losing it, and the IRS is well aware of how S-Corps may try to take advantage of the S-Corp structure. Because of this, the IRS has provided guidance and rulings pertaining to reasonable compensation, and they do enforce it. Trust us, you do not want to go through the headache of an audit, potentially losing S-Corp status, or having major tax penalties, which is why it is so important to take the time to understand reasonable compensation and determine a justifiable salary or hourly rate, for each employee that is also a shareholders in your S-Corp. Check out How to Keep the S-Corp Filing Status to learn more about ongoing S-Corp requirements and potential risks you can avoid.

That being said, it can be a fine line to walk, because obviously you also want to maximize the money saved on your small business taxes – that’s the whole point of the S-Corp election after all! Since every small business is unique, the best advice is going to come from a CPA Firm with accounting services for small businesses and ideally one that specializes in S-Corp accounting like ours. Let’s lay out some guidelines to help you get started thinking about your reasonable compensation.

How to Determine Reasonable Compensation for Your S-Corp?

Following some tedious court cases revolving around reasonable compensation and the general lack of clarity, the IRS issued some guidance and summarized the factors that the courts use to decide whether an S-Corp salary is considered reasonable. The intention is that this guidance can help S-Corp owners figure out their own justifiable reasonable compensation. But like all things IRS related, it’s not exactly in layman’s terms. Here’s the general guidelines and steps with hopefully more clarity and less legal jargon.

1. What kind of small business is the S-Corp?

First up, think about what your S-Corp business does and specifically how much profit is generated by the personal efforts of employees? A service business such as a law firm or family run restaurant likely has a lot of hands-on work by shareholder employees, which means the salary should reflect that. On the other hand, an S-Corp that has profits driven mainly by the business’s capital and assets may allow for lower salaries because there is less personal effort by the employee shareholders.

2. What role does the employee/shareholder play in the S-Corp?

Take the individual or yourself that you’re determining reasonable compensation for, and think about their qualifications, responsibilities, and how much time and effort they put into the business. A shareholder that doesn’t fill a role or provides very limited services may not need to be paid a salary at all. Or maybe a very qualified shareholder was a full time employee before, but they have since reduced their role- this could justify a decrease in reasonable salary. On the contrary, a previous shareholder with little prior qualifications has since taken on a larger role and devotes full-time effort to the business now- a salary reflecting their time and responsibilities would be in order.

3. How does the salary compare with the industry norms in other S-Corps, small businesses or big corporations?

Take a look at the services provided or the role filled by the shareholder employee and compare that to the compensation paid by other businesses to employees who fulfill similar roles. This should give you at least a starting point and a good gauge of what may be considered relatively reasonable compensation. A helpful question to ask is, “How much would I have to pay someone to replace them?”

4. How does the salary of the S-Corp shareholder compare to non-shareholder employees in the small business?

This may sound more complicated than it actually is. Just think about it in terms of a logical hierarchy. Take a local restaurant for example. A shareholder employee with 10 years of experience as a chef with culinary training would be paid more than recently hired non shareholder kitchen staff with little experience. Likewise, a shareholder who has more responsibilities than the highest paid non-shareholder should logically have a higher salary than the non-shareholder.

5. How does the S-Corp shareholder salary compare with the salary in prior years that the small business was operating?

Again, use common sense here. If a small business’s profits have risen substantially over prior years, but shareholder salaries have stayed the same, that may not always point to red flags, but it could, depending on the context and role of the shareholder employee. For example, it may not raise any problems if an employee of an electrical repair company whose primary role is an on site electrician continues to be paid the same salary year after year. But in contrast, it may raise flags if the operations manager who is also a shareholder and responsible for supervising all jobs and obtaining new business is paid the same salary year after year despite substantial growth in the business and profit increases. Additionally, if a small business just made the S-Corp election and then reduced the compensation of the shareholders, that could certainly raise some questions about whether the new compensation is reasonable.

6. What is the proposed salary as a percentage of total sales or profits?

Figuring out what percentage of total profit or sales makes up the shareholder employee’s compensation is an important tool to gauge how that percentage compares to the employee’s responsibilities and time contributions. It is also an excellent way to compare against the compensation paid by other businesses to employees who fill a similar position. Comparing the salaries as a percentage of the total sales or profits of a business eliminates the outside factors that could make a direct number to number comparison inaccurate such as geographic location.

7. How does the salary compare with distributions?

Although there are no specific requirements on how much an S-Corp should pay out in salary compared with distributions, it’s still smart to take into consideration this ratio since large distributions coupled with a small salary may increase the chances of IRS scrutiny. In contrast, a high salary coupled with small distributions will likely keep an S-Corp clear of scrutiny on their small business taxes, but they may be missing out on valid tax savings. Keeping conscious of this ratio, any changes to it, and the evidence that supports it as reasonable will help S-Corp small business owners stay on track and prepared if ever scrutinized.

Let’s Wrap it Up

Hopefully that cleared up some of the confusion surrounding reasonable compensation for S-Corps and can get you started in the right direction to determine what is reasonable for the shareholder employees in your S-Corp. The above may get you started, but like we said before, determining reasonable compensation is the crux of an S-Corp and it can be a fine line to walk. Give us a call and let our bookkeepers and s-corp accounting specialists help you decide the reasonable compensation for your specific situation and any other accounting services for your small business!

Haven’t made the S-Corp election yet? Head over to How to Make the S-Corp Election? to find out more about first steps. Still not sure if the S-Corp election is right for your small business? Take our quiz or check out Who Can Make the S-Corp Election? to find out if your small business is eligible to become an S-Corp and start saving money on your small business taxes.