Alright, S Corp owners, ready for a two-word horror story? Tax audit.
Running your S Corporation can be challenging for many reasons. Even if you’re a single-owner entity, you need to worry about obtaining proper business documentation, tracking expenses, and, of course, payroll. The latter brings us to the topic of this post: What is the best way to set your S Corp reasonable salary?
This post will provide you with four tips you can use to set an S Corp reasonable salary that won’t raise any red flags with the IRS.
S Corp Reasonable Salary: Why Use an S Corp?
Before we get into the nitty-gritty of setting an S Corp reasonable salary, let’s discuss S Corps more broadly. What is the difference between an S Corp and an LLC? Suppose you’re simply looking to start a single-owner business and limit your personal liability. In that case, either option may work, but if you meet the following requirements, using an S Corp has several advantages.
Related: 6 Tips for New Entrepreneurs
To form an S Corp, you must:
- Operate within the United States
- Have shareholders who are individuals, trusts, or estates (not partnerships or other corporations)
- Have 100 or fewer shareholders
- Have only one (1) class of stock
When you use an S Corp, you can enjoy benefits like pass-through taxation, personal assets protection, and dividend payments in addition to your salary. It is also easier to convert your S Corp into a C Corporation as your business grows if that is your ultimate goal.
S Corp ownership comes with challenges, however. The biggest challenge of owning an S Corp is meeting this business entity's strict requirements and regulations. You’ll need to follow IRS guidelines regarding who can serve as shareholders for your business, how many shareholders you can assign, what classes of stock are permitted, and more.
If you’re still thinking about operating an S Corp, you’ll need to be able to assign yourself a reasonable salary. Let’s take a closer look at the simple, four-step process you can use to set the right salary.
1. Understand Distributions vs. Salary
Your first step to setting your S Corp reasonable salary is to ensure you have a solid understanding of distributions versus salary payments. As an S Corp owner, you can receive compensation through both avenues. Let’s take a look at the differences between these two payment methods.
Distributions refer to profits and losses that pass to an S Corp owner as a shareholder. These earnings aren't considered wages and are not treated as income for tax purposes.
Salary, on the other hand, is the money you pay yourself. This payment is similar to the wages you would receive were you employed elsewhere. This is the type of payment we will discuss further throughout this post.
With this understanding of salary vs. distributions, let’s look at how you can properly set your salary.
2. Use IRS Guidelines
The official IRS guidelines for setting salaries are an incredible resource you can use when setting your salary. Your pay needs to stand up to IRS scrutiny come tax season, so using the IRS playbook to calculate that salary is a best practice.
The IRS judges appropriate salaries based on nine criteria:
- Qualifications: What is your background, including education and experience?
- Scope of Duties: What does the job you’re performing look like?
- Time Worked: How many hours do you plan to work each week?
- Size of Business: A small business will, on average, offer lower compensation than a larger business.
- Economic Conditions: The overall and local economic conditions impact what the IRS considers a reasonable salary.
- Whether Salary is Predetermined: Is your salary determined upfront, or will you pay yourself only after the end of the tax year based on earnings?
- Prior Salaries: If you paid yourself $80,000 last year but only plan to pay yourself $20,000 this year, it may raise a flag for the IRS come tax time.
- Salaries of Other Employees: Do you have other employees? If so, you must consider your salary in relation to theirs.
- Comparable Salaries: Lastly, the IRS will measure your salary against salaries for comparable roles at similar organizations.
When setting your reasonable salary, ensure that your chosen salary stands up to scrutiny against these measures. For example, if you have a Master’s degree and are doing the work of a high-level executive, it may not be wise to pay yourself the salary of an entry-level office worker.
3. Compare to Salary Standards in Similar Roles
Using the IRS guidelines to check your chosen salary is all well and good, but what if you don’t even know where to start? That’s when you turn to our third step: Examining the common salary ranges for similar roles at different organizations.
Use resources like the Bureau of Labor Statistics, sites like PayScale or Glassdoor, or RCReports to gather information. Examine the reported salaries of other professionals performing similar job duties in similar industries.
Once you have gathered this information, you’ll be able to set your salary based on what the market has already determined to be a reasonable salary for your work.
As a small or single-owner S Corp owner, you may find that your role stands between a few standard roles due to the multiple hats you’re required to wear. In this case, you may want to average the salaries to set your reasonable S Corp salary.
4. Should I Use the S Corp 60/40 Rule?
If you’ve done much research regarding S Corp reasonable salaries, you may be asking, “What about the 60/40 rule?” by this point in the post.
One seemingly common strategy S Corp owners use is to split their S Corp revenue, earmarking 60% for salary and keeping the remaining 40% as distributions. Though this split may work for some S Corporations, we caution against using this method without further consideration.
This type of calculation is too arbitrary to stand up to scrutiny in the face of an IRS audit. Additionally, you may end up over-paying on taxes by paying yourself too high a salary for your work if you use this method.
Beyond the S Corp Reasonable Salary: Processing Payroll for Your Business
With the help of these tips, you should have all the tools you need to set the perfect S Corp reasonable salary for yourself. But setting your salary is only the beginning of your adventures in managing your S Corp.
Whether you’re planning to grow your business or keep it small, you’ll need to learn more information about how to properly manage payroll for your small business to avoid running into challenges down the line.
Explore our resource, the Connected Guide for Small Business Payroll, for more information, or get in touch with a Connected Service Representative today.