S-Corporation Compensation: What’s ‘Reasonable’?
S-Corporations are one of the most common entity structures. For federal tax purposes, S-Corporations pass corporate income, losses, deductions, and credits through to its shareholders. One of the biggest benefits of being an S-Corporation is reduced self-employment tax. With this perk, however, comes confusion for shareholders.
In a previous blog post, we asked the question “How do I get paid?” and answered by saying this: “The most common LLC entity structures are sole proprietorships, partnerships, and S-Corporations. As a business owner of a sole proprietorship or partnership, you cannot be on payroll or have payroll tax withholdings. The IRS states that S-Corp owners must take a ‘reasonable salary’ (via payroll).”
As a shareholder, you are an employee of the S-Corp if you perform more than minor services and are entitled to receive ‘reasonable’ compensation in exchange for those services.
What Makes Compensation Reasonable?
Examples of the factors the IRS uses when determining ‘reasonable’ compensation include:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
Determining compensation levels for shareholders is a balance of tax savings and risk tolerance.
What’s the risk of not having a reasonable compensation?
Two friends, Tim and Al, own a hardware store. Tim and Al are 50/50 shareholders who both work fulltime. The hardware store makes $200,000 taxable income per year. Al pays himself a reasonable compensation of $40,000 for the year. Tim wants to save taxes, so he pays himself $5,000 for the year out of the S-Corp. Tim’s compensation is a red flag because it does not match any of the IRS’ established criteria above. As a result of Tim’s unreasonable salary, the S-Corp is under an IRS payroll audit. The IRS will determine his “reasonable” salary then charge the company back payroll tax, penalties, and interest.
How does Reasonable Compensation Impact Income Taxes?
The S-Corp will issue each shareholder a Schedule K-1 which will reflect his/her percentage of the S Corporation’s income, loss, and deductions in addition to the W2. Your paycheck is a great way to take out additional federal and state withholding to help cover the tax liability from the net taxable profit of your S-Corp. If done correctly, this will spread your withholding over the year and avoid underpayment penalties and interest on late estimate payments.
Remember that your wages are different from distributions. Distributions are not typically taxable and are taken out in proportion to your ownership percentage.