S Corporation Reasonable Compensation: 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 Corporation 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 S Corporation reasonable compensation. After reading, you can confidently evaluate whether S Corp status is right for you and your business.
What does the IRS consider reasonable compensation?
Reasonable compensation is a wage or salary an S corporation pays a shareholder-employee to perform services for the business. There are no rigid guidelines for reasonable compensation. The tax code or IRS does not define reasonable compensation.
The regulations say reasonable compensation is an amount paid for like services by like enterprises under like circumstances. That is, your S corp compensation should be similar to that of a comparable business that would pay someone to perform the same services. Reasonableness is determined from all relevant facts and circumstances.
Compensation paid for comparable services is an important factor, but it is not a stand-alone safe harbor or an exact industry-standard requirement.
Why does reasonable compensation for S corporations matter?
An S corporation must treat a shareholder who performs more than nominal services for the S corporation and receives, or is entitled to receive, remuneration as an employee for federal employment tax purposes. Payments to a shareholder-employee for services must be characterized as wages to the extent of reasonable compensation before nonwage distributions are made. 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 like employee wages in a traditional employer/employee relationship. Social Security and Medicare taxes must be paid out of your wages –called FICA tax. These taxes are split 50/50 between you and your S Corp business.
The corporation generally withholds the employee share of Social Security and Medicare taxes from wages and pays the employer share. 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? After paying reasonable compensation and satisfying other corporate and tax-law requirements, an S corporation may make distributions to its shareholders.
A shareholder distribution is not subject to self-employment tax, made up of Social Security and Medicare taxes (resulting in potential tax savings), but its federal income-tax treatment depends on matters such as stock basis, accumulated earnings and profits, and the amount distributed.
Note, the IRS may recharacterize purported distributions as wages when they represent compensation for services.
Why can’t I take profits from my business instead of a reasonable salary?
Many S corporation owners have tried to take distributions from their S Corps instead of paying themselves a reasonable salary. They may wish to do this rather than receive S Corp reasonable compensation to lower their employment tax liability. However, shareholder-employees who perform services for the corporation generally must receive reasonable compensation for those services.
The IRS may reclassify distributions and fringe benefits as compensation. The reclassified amount is subject to employment taxes. Since the business did not pay these taxes correctly and on time, penalties and interest may 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. Many factors contribute to what the IRS may consider reasonable compensation for an S corporation owner versus unreasonable. Some Tax Court decisions have focused on the following five factors:
- The character and financial condition of the business
- The role the shareholder plays in the corporation, including their position, hours worked, and duties performed
- The business’s compensation policy for all employees and the shareholder’s individual salary history, including the corporation’s internal consistency in establishing the shareholder’s salary
- How the shareholder’s compensation compares with similarly situated employees performing the same services within the industry are paid
- Whether a hypothetical independent investor would conclude that there is an adequate return on investment after considering the shareholder’s compensation
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 a reasonable salary?
Some resources encourage setting reasonable compensation between 60% and 40% of the business’s net profits. The IRS has not adopted a 60/40 formula, and no fixed percentage of profits is a safe harbor. Reasonable compensation depends on the services performed and all relevant facts and circumstances, including comparable pay when available.
How do I pay myself?
Paying yourself is the same as paying any other employee. You’ll need to decide on a payment schedule and method of payment. Then, devise a tracking system. The business must withhold the appropriate employment and income taxes when it pays you. The business must also file payroll tax returns. The business generally files IRS Form 941 quarterly, unless the IRS has authorized annual filing on Form 944, and files IRS Form 940 annually when subject to federal unemployment tax. It must also furnish Form W-2 to the shareholder-employee and file the required copies by the applicable deadline.
Paying yourself and staying compliant with payroll taxes doesn’t have to be complicated. If you’re stressed, Block Advisors Payroll service can take some of the burden off your shoulders.
How often should I pay myself?
How frequently you pay yourself 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 you pay yourself isn’t as important as ensuring the amount is reasonable. You also want to ensure all applicable taxes are deducted and paid correctly.
Have more S corporation 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 as you consider what compensation is reasonable for your S corporation and particular situation.
On average, Small Business Certified Tax Pros have 14 years of experience. Their wealth of knowledge can help you maximize your tax situation – both for your business and for you personally. Reach out today to schedule an in-person or virtual appointment.
This article is for informational purposes only. The content may not constitute the most up-to-date information and should not be construed as legal advice.