Reasonable Compensation and S Corps: A guide for small business owners

As a small business owner, you may be considering making an S Corp election using Form 2553 to take advantage of the tax benefits that S Corp status provides. One of the things that small business owners may overlook when considering making an S Corp election is reasonable compensation. In this article we will address some common questions about reasonable compensation for S Corps. After reading, you will be equipped to confidently evaluate whether S Corp status is right for you and your business.

What does the IRS consider reasonable compensation?

An S Corp Business Owner holds a paycheck

Reasonable compensation is a wage or salary that you pay yourself as a business owner to perform services for your business.  To be considered reasonable by the IRS, the amount paid must be equivalent to what a similar business would pay someone to perform the same services.

Why does reasonable compensation for S corporations matter?

Reasonable compensation is important. The IRS requires that S Corporation shareholders that perform significant services to the business be paid reasonable compensation. As a small business owner, if you work for your S Corporation, you must pay yourself reasonable compensation for the work that you do.  If you do not, you put yourself at risk for penalties.

How is my S corp reasonable compensation taxed?

When you are paid reasonable compensation, your wages are taxed the same way employee wages would be taxed in a traditional employer/employee relationship.  Social Security and Medicare taxes must be paid out of your wages – sometimes called FICA payments. These taxes are split 50/50 between you and your S Corp business. Additionally, the business will likely have to pay state and federal unemployment tax on your wages.

Is an S Corp the best option for my business?

Answer six quick questions to help you find your entity structure fit.

What happens if your S Corp earns profits in excess of your reasonable compensation? In this case, you can take those profits as distributions from the business.  Social Security and Medicare taxes do not apply to these distributions (resulting in potential tax savings).

Why can’t I just take profits from my business instead of a reasonable salary?

Many business owners have tried to take distributions from their S Corps instead of paying themselves a reasonable compensation. They may do this to lower their employment tax liability. This strategy is risky. 

If you’re audited, tax-free distributions and fringe benefits can be reclassified as compensation by the IRS. The reclassified amount is subject to employment taxes. Since the business did not pay these taxes correctly and on time, penalties and interest would apply. The penalties can be substantial. It is important to pay yourself reasonable compensation when you perform services for your S Corp.

Learn what to do if you’re hit with IRS business tax penalties.

How do you determine an S Corp reasonable salary?

There is no standard formula for calculating reasonable compensation. There are many factors that contribute to what the IRS considers to be reasonable.  Some factors include:

  • The financial condition of the business
  • The duties you perform
  • The number of hours you work
  • The business’s compensation policy for all employees
  • What other similarly situated employees performing the same services within the industry are paid
  • Your qualifications such as degree, certifications, work history, etc

This is a facts and circumstances analysis, meaning that the IRS will evaluate each situation individually.  The list above is not exhaustive. You should carefully consider your situation when deciding what your reasonable salary should be.

Finally, know that the amount you decide to pay yourself may not be the same each year.  As your business and duties evolve, your compensation will likely change.  Reviewing your reasonable salary each year is in your best interest. This is especially true during the early years of your business when revenues and profit may fluctuate greatly.

What is the rule of thumb for reasonable salary?

You may or may not have heard of the S Corp Salary 60/40 rule. The guideline refers to setting reasonable compensation between 60% and 40% of the business’s net profits. This guideline is not set by the IRS. It should not be relied on as the only factor when setting reasonable compensation. However, it can be a useful starting point when determining reasonable compensation.

How do I pay myself?

Paying yourself is the same as paying any other employee. You’ll need to decide on a payment schedule, method of payment, and devise a tracking system. When the business pays you it must withhold the appropriate employment and income taxes. The business must also file payroll tax returns quarterly. These actions often require using IRS Form 941 and IRS Form 940. Additionally, the business must also issue you a W-2 as it would for any other employee.

Paying yourself and staying compliant with payroll taxes doesn’t have to be complicated. If you’re feeling stressed, Block Advisors Payroll service can make it even easier.

How often should I pay myself?

How frequently you pay yourself really depends on the needs of your business. If you have employees, it may be easiest to pay yourself on the same schedule that you pay your employees. Alternatively, some business owners choose to pay themselves quarterly. Others may make a one-time payment at the end of the year. The frequency that you pay yourself isn’t as important as ensuring that the amount is reasonable. You also want to ensure all applicable taxes are deducted and paid correctly.

Have more S Corp reasonable compensation questions?

We’ve covered the basics of reasonable compensation, but you may still have questions. We’ve got your back. Block Advisors Certified Small Business Tax Pros can help you think through what compensation is reasonable for your particular situation.

On average, Small Business Certified Tax Pros have 12 years’ experience. Their wealth of knowledge can help you maximize your tax situation – both for your business and you, personally. Reach out today to schedule an in-person or virtual appointment.   

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