As an accountant I hear this question a lot ” What’s Reasonable Salary for S Corp Owners? “I advice small business owners everyday “It Depends”. Its sounds like a vague answer, but it is very true as reasonable compensation is based on various facts and circumstances.
Many Small Business Owners setup S Corp to help lower self employment tax. Self employment tax is 15.3% for up to $142, 800 (for 2021) of self employment earnings.
S Corp allows you to pay payroll taxes only on the W2 amount and helping you save Self employment taxes on K1 or Distributions.
Internal Revenue Code makes it mandatory for shareholder of S Corp to Pay a Reasonable Salary.
What’s A Reasonable Salary for S Corp Owners?
S Corp shareholder must pay reasonable compensation to its shareholder who work or perform services for the business.
Reasonable compensation can be determined by looking at market rate of what type of work the shareholder is doing and what is the market salary for that position.
For example if the shareholder runs a restaurant and restaurant manager going salary is $60,000, then S Corp needs to pay Shareholder 60,000 or more in W2 Salary.
How to determine Reasonable Compensation for S Corp Owners?
S Corp compensation is based on many factors but here are some key items that you should consider when deciding reasonable compensation
- Duties and responsibilities of Shareholder: What is shareholder doing, Managing business or doing sales or marketing work
- How much Time and effort shareholder devoted to the business(Shareholder working fulltime or part-time)
- Market rate for type of work performed(example Restaurant Manager Rate may be $60,000 Per year)
- Training and Experience for the type of work performed. For example S Corp Reasonable salary for a physician will be approximately $300,000 which is much higher than a Medical assistant which may be $40,000 per year.
How to pay yourself a salary for S Corp Owners?
There are 2 different ways of taking money from a S Corp for S Corp Owners(Shareholders).
First is W2 Salary and Second is K1 Distribution of Profits. You pay Social Security & Medicare taxes on W2 but you don’t need to pay Social Security and Medicare Taxes(Self Employment Taxes) on K1 Distributions.
S Corp need to engage a payroll company and run proper payroll and file appropriate payroll forms such as 941, 940 and W2.
Reasonable Salary & Audit Risk
Over last 3 years we have seen IRS Audits Skyrocket due to Shareholders not taking any salary at all or not taking enough in W2 Salary.
IRS has a separate box for “Officer Compensation” on the S Corporation Income Tax Return 1120S, if left blank or if it has a very small Salary amount can result in IRS Audit.
What happens if you don’t take Reasonable Compensation?
If IRS auditor determines that you are not taking or not taking enough reasonable compensation then under section 7436 of the Internal Revenue Code, IRS can reclassify S Corp distribution or profits as W2 Salary forcing you to pay employment taxes for Employee and Employer side.
Tax Court has upheld IRS’s position on Reasonable Compensation. You can see Court Case for more info: