Filing as an S corporation, also known as S subchapters, offers several tax savings, making them appealing to business owners.
S corporations don’t pay taxes on revenue—the owner does. The business structure allows the S Corp to avoid double taxation, unlike a C Corps, where the business and the owner must pay income taxes.
Business income passed on to S Corp owners avoids taxation at the corporate level. But S Corp owners must be careful about how they pay themselves. They must receive an amount deemed “reasonable” by the IRS.
What counts as reasonable pay? The answer isn’t so straightforward. Here, we’ll discuss different salary and distribution schemes and how to set the right salary for yourself.
Does S Corp Have to Pay Salary?
Yes, these business entities must pay their employees and shareholders a reasonable salary. The salary for an S Corp shareholder-employee is part of their compensation. Therefore, the business entity must treat the salaries as employee wages.
After paying out salaries, the entity can pay the remaining profit via distributions. Distributions are money earned by S Corps that is “passed through” or paid out as dividends to shareholders.
S corporations differ significantly from partnerships or C corporations. Unlike partnerships, they are not subject to personal holding company tax. Any income earned is subject to taxation only one time.
A C Corp or C subchapter is subject to double taxation. First, the entity must pay a corporate income tax for its income minus the deductions, losses, and credits. Then it pays out again to shareholders on the after-tax income via dividends.
The benefit of S Corps is that they prevent being taxed twice (double taxation). Instead, these corporations are subject to single-level taxation. They do not have to pay income tax at the corporate level as long as they distribute the salaries among the shareholders and report them on individual tax returns. The elimination of the double taxation scheme makes sense when considering that 70% of S corporations are under ownership by one person.
Section 1368 is in place to regulate the distributions, depending on whether or not the S corporation had earnings and profits. However, it’s up to the owner of the S corporation—the owner or the officers and directors—to decide how much to pay the employees for a salary.
What Is a Reasonable Salary for an S Corporation?
The salary of S Corp owners is one of the most hot-button issues for the IRS. The business structure allows the shareholder—who is often the employee as well—to save on paying taxes for Social Security and Medicare. Therefore, the IRS is rigorous when examining the amount of salary paid and whether it is reasonable.
The IRS deems “reasonable pay” to be the amount similar businesses pay for the same (or similar) services. This rule is very vague. Therefore, you must do your research and pay yourself a reasonable salary.
To do this, you need to consider all the factors the IRS does. They include earnings, profits, day-to-day roles, the industry’s average, and more. They will also consider factors such as training, qualifications, and experience to determine whether the salary is reasonable.
Let’s look at two popular rules that claim an easy way to calculate S Corp salaries and why you should think twice before using them.
The S Corp 50/50 Rule
Profit split evenly (50/50) between salary and profit distribution is one way to avoid leaving any money on the table. For example, if an S Corp owner earns $50,000 annually, they’d pay themselves a $25,000 salary and $25,000 profit distribution.
The S Corp 60/40 Rule
The 60/40 rule describes where owners pay 60% of their salary and the remaining 40% as a distribution. For example, if an S Corp owner earns $50,000 annually, they’d pay themselves a $30,000 salary and a $20,000 profit distribution.
S Corp Salary Example
The 50/50 and 60/40 rules offer different models of setting salaries and distributions. However, it’s worth noting that the IRS has not approved these officially, so it’s not always a reliable payment scheme. There are also other issues with these models that might make them unsuited to your S corporation.
For starters, the salary you deem reasonable for your work may not slide with the IRS, leading to overpayment of your taxes or penalties for low-balling your pay.
Another issue is that the salary should account for the amount that the role earns in the industry. The 50/50 and 60/40 rules do not always align neatly with industry trends.
For example, let’s say an S Corp owner has a business profit of $100,000 per year, but the Bureau of Labor Statistics shows the average salary for their job to be $80,000. In this case, neither one of the rules would apply.
The 50/50 rule would pay the owner $50,000, while the 60/40 rule would pay them $60,000. Both figures are much less than the median salary for similar jobs.
How to Determine a Reasonable Salary
The 50/50 rule and 60/40 rules are good starting points for how you can determine a reasonable salary. However, the IRS will call foul play if you don’t pay a reasonable salary similar amount to that of others in your field.
Therefore, follow the criteria set in place by the IRS regarding what they consider reasonable:
- Training and experience
- Duties and responsibilities
- Dividend history
- Time devoted to business
- Efforts devoted to business
- Payments made to non-shareholder employees
- Compensation agreements
- The use of a formula to determine compensation
You must leverage the above with third-party research to determine a reasonable salary. What are others in a similar position earning? You can find statistics about employee pay on the Bureau of Labor Statistics website. This site is free and includes detailed salary information for hundreds of jobs.
Note: The “reasonable salary” rule only applies if S Corp owners and other shareholders take a distribution from the business profits. The IRS can’t impose the minimum salary requirement if the company isn’t earning enough to pay a salary comparable to others in your field.
How S Corporations Run Payroll
S corporations run payroll by calculating income, unemployment, and FICA taxes. The calculations are based on the income earned during a given pay period.
While they must run payroll, S Corps have more flexibility compared to other business entities, especially if there’s only one shareholder-employee. In this case, individuals typically pay themselves in a few small payments and a hefty year-end bonus.
How Do S Corp Owners Pay Themselves?
By this point, it should be clear that S Corp owners are considered shareholder-employees and need to pay themselves via a reasonable salary and distributions.
Here’s how you should pay yourself and other shareholders:
- Set a reasonable salary.
- Calculate payroll and taxes.
- File federal quarterly payroll taxes.
- Record payroll transactions.
- File state payroll taxes.
- Prepare annual tax returns.
How Many Shareholders Can an S Corp Have?
An S Corp can have 1 to 100 shareholders. Ranks are limited to individuals, trusts, non-profits, and estates—they cannot have institutional investors. Every shareholder must be a United States resident.
Is There a Minimum Salary for S Corp?
No, there is not a minimum salary for S Corp. The IRS can’t require a minimum salary for self-employed workers. This requirement only applies if S Corp owners are paying distributions to shareholders. Then, they must receive a reasonable salary for their work at the company.
How Are S Corp Distributions Taxed?
Taxes on S corporation distributions treat them as personal income. After paying salaries and expenses, the remaining profits are passed to shareholder-employees as distributions and reported on individual income tax returns. If you’re a Business-of-One, you’ll need to report all profits after your salary on your individual income tax return.
What Happens if an S Corp Does Not Pay Salary?
If an S Corp owner attempts to evade payroll taxes by disguising salaries with distributions, they can face penalties of up to 100% plus negligence penalties. For this reason, it’s better to do their due diligence and prevent having problems with the IRS.
Determining the Best Course of Action
Running an S Corp can save money on taxes by avoiding double taxation. However, with great tax savings comes even greater responsibility. You must understand how to pay yourself and prevent suspicion from the IRS.
In most situations, it’s best to consult a CPA to avoid trouble with the IRS. If the IRS deems the salary you’re paying yourself is unreasonable, the penalties can be painful.
Ultimately, you need to pay yourself the amount you deserve while meeting tax requirements (just like you would expect from an employer).
To learn more about what amount is deemed reasonable for your business, get in touch with MI Tax CPA today!