Examples:

• • Dr. Smith is the sole owner and practitioner in his S corp medical practice. He must pay himself a reasonable salary for his services before receiving distributions.
  • Karen works full-time in her S corp consulting business but tried to avoid FICA taxes by taking only distributions. She violated the reasonable salary rule.
  • Jeff owns an S corp restaurant and performs substantial services. He can receive distributions of profit but must first pay himself a reasonable wage.
  • Maria is the CEO of her S corp and paid herself $30,000 despite $500,000 in revenue. The IRS will likely find her salary unreasonably low.
  • Tanya invested in an S corp but doesn’t work in the business. She’s not subject to the reasonable salary rule since she’s not a shareholder-employee.

How to Proceed:

• • Determine if you’re a shareholder-employee providing substantial services to the S corp, making you subject to the reasonable salary requirement.
  • Identify all the services you provide to your S corp as an employee-owner throughout the year to help justify your salary level.
  • Recognize that all compensation for your employee services must be paid as W-2 wages subject to employment taxes before profit distributions.
  • Understand that the IRS can recharacterize distributions as wages and impose penalties if your salary is found to be unreasonably low.
  • Consult a knowledgeable tax professional who can advise you on reasonable salary determinations and help you stay compliant.

FAQs:

• • Is the reasonable salary rule actually a law? Not specifically, but multiple tax courts have upheld it and the IRS enforces it as an anti-tax avoidance measure.
  • Does the IRS consider certain factors in determining reasonable salary? Yes. Training, experience, duties, company size, complexities, time devoted, and comparable market data.
  • Can I pay myself 100% of my S corp profits as a salary? Possibly, if it reflects reasonable compensation for your services, but you’d pay more payroll taxes.
  • Should I pay myself a salary if my S corp loses money? Yes, you should pay reasonable compensation for any services provided, even in unprofitable years.
  • What’s the average “safe harbor” for S corp salary vs. distribution split? The 60/40 salary/distribution rule of thumb no longer applies. It’s always case-by-case based on facts & circumstances.

Examples:

• • Jim’s 20 years of experience and advanced degree warrant a higher salary than a new grad in a similar role at his S corp tech firm.
  • As the head chef and manager working 60+ hours a week, Sasha’s salary should reflect her substantial duties at the S corp restaurant.
  • Mike’s $50,000 salary was found unreasonable for the CEO of a $5M manufacturing S corp, given the business’s size and complexity.
  • Jada researched salaries for commercial real estate brokers in her metro area to help determine a reasonable wage for her S corp role.
  • Bob compared his $35,000 officer salary to the $55,000 he pays his non-owner VP of Sales, who has similar qualifications and duties.

How to Proceed:

• • Make a list of your key experience, skills, certifications and training that contribute to your business’s success and warrant higher pay.
  • Write out a detailed description of your role in the company, including day-to-day duties, management responsibilities, hours worked, etc.
  • Assess your company’s size in terms of revenue, assets, employees and any complex processes that may justify a higher salary for your position.
  • Use online salary tools and industry compensation surveys to find market data on what similar roles pay in businesses like yours.
  • Pull historical payroll records to compare your owner salary to amounts paid to non-owners in similar roles, and document any compensation pattern.

FAQs:

• • How much weight does the IRS give to comparable salary data? A lot – they’ll look for objective market data to gauge the reasonableness of your S corp pay.
  • What if there are no direct comparables for my unique role? Find roles with similar key duties, qualifications and authority level to provide a reasonable range.
  • Should I pay myself the same salary each year? Not necessarily – reasonable compensation can change as your duties, qualifications and business size/complexity change.
  • Does the IRS consider geographic location for reasonable salary? Yes, compare your pay to similar roles in your specific area, as market rates vary by location.
  • What if I do multiple jobs as the owner? Consider the market value of each of the distinct roles you fill and sum them up to justify your total salary.

Examples:

• • Tom used data from a physician compensation survey to help set his salary for his S corp medical practice.
  • Jennifer figured her S corp would have to pay $75,000 to hire an outside business development manager to do what she does, so used that to justify her salary.
  • After paying Jose his $120,000 officer salary, his S corp had just a 2% ROI, which likely wouldn’t satisfy an independent investor, suggesting his pay is too high.
  • Andrea used a salary database, assessed her duties and weighed her S corp’s $2M revenue to land on a $95,000 salary.
  • Marcus considered his 10 years of experience, $500K gross receipts, long hours and CEO/sales/finance roles to set his pay using multiple factors.

How to Proceed:</strong

• • Research relevant salary surveys from reputable sources like the BLS, industry groups or compensation consulting firms.
  • Calculate what your business would have to pay a non-owner to perform your same duties and consider that in setting your salary.
  • Assess if your total compensation would leave enough profit to give an independent investor a reasonable return on their investment.
  • Make a list of all pertinent factors like your qualifications, scope of duties, company finances, market data, etc. to support your salary rationale.
  • Work with your CPA or tax advisor to crunch the numbers, weigh all relevant variables and use multiple approaches to land on a defensible salary figure.

FAQs:

• • Can I use just one approach to determine reasonable compensation? You can, but the IRS prefers a multi-factor analysis weighing all relevant variables.
  • What sources of salary data are most reliable? Government agencies like the BLS, well-known industry groups and established compensation consulting firms.
  • How do I value my S corp pay if I do multiple jobs? Break out the market rate of each key role you perform and add them together.
  • What’s considered a “reasonable” ROI under the independent investor test? At least 10-12% after owner salaries are paid, but it varies by industry.
  • Is it better to overpay or underpay myself to be safe? Underpaying is riskier, as the IRS is more likely to challenge unreasonably low compensation.

Examples:

• • Erica drafted a 3-page memo detailing the salary research, independent investor test and multifactor analysis behind her $80,000 salary determination.
  • In the IRS exam, Amir produced a compensation survey, CPA-prepared ROI analysis and detailed job description to substantiate his pay.
  • Tamika’s corporate minutes clearly showed that her $125,000 salary was discussed and approved at the annual board meeting.
  • Devon’s spreadsheet compared his S corp owner salary to his prior year compensation as a non-owner employee to show its reasonableness.
  • Jen met with her CPA each December to re-evaluate her reasonable pay based on that year’s financials and any changes in her role.

How to Proceed:

• • Write out a clear, concise explanation of your reasonable compensation analysis and the critical factors supporting your salary determination.
  • Gather and attach all relevant documents like compensation surveys, financial statements, job descriptions and board resolutions.
  • Maintain orderly and up-to-date corporate records including minutes authorizing compensation and detailed payroll registers.
  • Set calendar reminders to annually review and adjust your compensation levels based on any changes in responsibilities, qualifications, business growth, etc.
  • Store your compensation memo and supporting evidence securely with other important corporate files for easy retrieval if needed.

FAQs:

• • How long should I keep reasonable compensation documentation? At least 3 years from your return’s due date, but preferably 6-7 years in case of an audit.
  • Do I need a compensation consultant to set my S corp salary? Not necessarily, but working with a CPA or tax advisor to document your analysis is wise.
  • Should I regularly review and adjust my salary? Yes. Annually is best practice to account for any major changes in your role, market conditions or business financials.
  • What if I can’t find an exact salary match for my S corp role and industry? Use the closest comparable data and document how you adjusted it to fit your situation.
  • Do I need a board resolution for my own salary if I’m the only owner? It’s still best practice to annually document your compensation analysis and approval in the corporate minutes.

Examples:

• • Nick thought he’d save on payroll taxes by taking all his S corp’s $200,000 profits as owner distributions, but got audited for paying no salary.
  • Alisha paid herself just $35,000 from her S corp IT consulting practice netting $150,000, an unreasonably low salary the IRS challenged.
  • Steve’s CPA advised him to pay 40% of his S corp’s profits as salary and 60% as distributions, but with no market data to support those ratios, he couldn’t substantiate it when audited.
  • Despite working 50+ hours a week managing her successful S corp salon, Tanya paid herself no salary at all, an obvious IRS audit target.
  • Jim tried to dodge payroll taxes by characterizing all his attorney pay as distributions until the IRS recharacterized most of it as wages.

How to Proceed:

• • Work with your CPA or financial advisor to clearly separate reasonable compensation for your services from profits paid as distributions.
  • Don’t try to avoid payroll taxes by paying yourself an unreasonably low salary; it’s an audit red flag. If you are are not sure, err on the side of overpaying.
  • Never pay yourself $0 salary if you’re working in the business; you must take some compensation as W-2 wages first before distributions.
  • Don’t just guess a salary amount or use a standard ratio. Tie your compensation to objective factors and market data specific to your situation.
  • Never ignore the issue of reasonable compensation or fail to pay yourself at least some salary if you provide substantial services.

FAQs:

• • Is it safer to overpay or underpay my S corp salary? Overpaying is generally safer. Chances of audit are higher and penalties steeper for unreasonably low pay.
  • What’s considered an unreasonably low S corp salary? There’s no bright-line test, but in general, anything under 50% of your economic benefit from the S corp is risky.
  • Can I ever pay zero salary if my S corp loses money? You may be able to justify $0 salary in a year with significant losses, but it’s still risky if you worked for the business.
  • Should distributions always roughly match my salary amount? Not necessarily. The salary/distribution ratio can vary widely based on industry, financials and your role.
  • How do I explain a big salary jump to the IRS if I was underpaid before? Base your explanation on objective factors like business growth, expanded duties, rising market pay, etc.

Questions: Reasonable Salary Basics

• • 1. What type of S corp owners must pay themselves a reasonable salary?
    • A) All shareholders
    • B) Only those who work in the business
    • C) Just the majority owner
    • D) Any shareholder taking distributions
  • 2. How should S corp owners pay themselves to comply with the reasonable compensation rule?
    • A) W-2 wages
    • B) 1099 payments
    • C) Distributions
    • D) Cash payments
  • 3. Which government agency focuses on reasonable compensation compliance?
    • A) IRS
    • B) DOL
    • C) SBA
    • D) SEC
  • 4. What’s the primary purpose of the reasonable compensation requirement?
    • A) To ensure S corps aren’t used to avoid payroll taxes
    • B) To limit owner salaries to a “reasonable” amount
    • C) To maximize S corp tax deductions
    • D) To equalize owner and employee pay
  • 5. What’s a potential consequence of paying unreasonably low S corp compensation?
    • A) Distributions could be reclassified as wages
    • B) Loss of S corp tax status
    • C) Penalties and interest on unpaid payroll taxes
    • D) All of the above

Answers: Reasonable Salary Basics

• • 1. B) Only S corp shareholders who provide more than minor services to the company must pay themselves a reasonable salary.
  • 2. A) Shareholder-employees must take reasonable compensation as W-2 wages subject to normal payroll taxes first, then can take remaining profits as distributions.
  • 3. A) The IRS is the agency that enforces the S corp reasonable compensation requirement as a way to prevent payroll tax avoidance.
  • 4. A) The core aim is to stop S corps from paying unreasonably low salaries to active owners to dodge Social Security, Medicare and unemployment taxes.
  • 5. D) If the IRS finds owner pay unreasonably low, it may reclassify profit distributions as wages, assess unpaid payroll taxes, penalties and interest, and even revoke S status in extreme cases.

Questions: Determining Reasonable Compensation

• • 1. What key factors should S corps consider in setting reasonable salaries?
    • A) Owner qualifications and experience
    • B) Nature, extent and scope of owner’s work
    • C) Company size and complexity
    • D) All of the above
  • 2. What’s a common method S corps use to help determine reasonable officer compensation?
    • A) Owner’s personal budget needs
    • B) Comparable salary data for similar positions
    • C) Percentage of gross profits
    • D) Average pay for all employees
  • 3. Under the independent investor test, reasonable compensation should allow an S corp to provide what minimum return on investment?
    • A) 5-7%
    • B) 10-12%
    • C) 15-20%
    • D) 25-30%
  • 4. The cost approach to reasonable compensation looks at what factor?
    • A) Shareholder’s personal cost of living
    • B) Cost to hire a non-shareholder to perform the owner’s duties
    • C) Cost of the owner’s education and training
    • D) Cost of wages as a percentage of revenue
  • 5. When considering comparable salary data, it’s important to look at pay for similar roles in what geographic area?
    • A) Local area only
    • B) Statewide
    • C) Same region of the country
    • D) Nationally

Answers: Determining Reasonable Compensation

• • 1. D) The IRS considers many factors like the owner’s qualifications, role, duties, hours worked, company size and more to gauge reasonable pay.
  • 2. B) Looking at objective market salary data for similar positions in comparable firms is a common approach to support reasonable pay.
  • 3. B) Reasonable compensation should leave S corp profit sufficient to give an independent investor a 10-12%+ return in most cases.
  • 4. B) The cost approach looks at the cost of hiring an outsider to perform the shareholder’s duties, which can help justify their salary level.
  • 5. A) Comparable salary data is most relevant when it reflects pay for similar positions in your specific local area and labor market.

Disclaimer

The tax information in this article discussing the reasonable compensation requirement for S corporation owners is general in nature and not a substitute for individualized advice.

To ensure compliance with IRS requirements for your particular situation, please consult with a qualified tax professional. They can evaluate your S corporation’s financials, advise you on a reasonable salary determination, and help you properly document and report your compensation.