Like most of our Blog posts, this was born out of many questions from clients about this topic. So we decided to post this as a resource for your and any other S-corp business owner out there.
Here’s the issue: how do you pay yourself as an owner of S-corp and stay out of trouble with the IRS?
Let’s break this down into the two ways that S-corp owners can get paid from their company:
- Wages through payroll
- Shareholder Distributions
As we look into both of these, keep in mind what the IRS says about S-corp owners that work in their company, aka owner/employees.
“Distributions and other payments by an S corporation to a corporate officer must be
treated as wages to the extent the amounts are reasonable compensation for services
rendered to the corporation.”
https://www.irs.gov/pub/irs-news/fs-08-25.pdf
So if you’re an S-corp owner and you work in the business providing services, then generally, you must pay yourself reasonable compensation. This must be done through a payroll service so that the proper taxes can be withheld to the IRS and your state agencies. For a low-cost easy solution, we like Gusto quite a bit.
Quick note about Shareholder Distributions
Shareholder Distributions are a return of equity to the shareholder/owner. So that means there must be equity in the company for distributions to be made. Figuring out your equity in the company can be complex so we’ll touch upon that in a separate post.
Shareholder Distributions are preferable over wages in that there are no payroll taxes on the funds coming out and going to the shareholder. Most S-corp shareholders have some form of this going on. Whether it’s direct transfers from the bank account or using company funds for personal items, both are classified as Distributions.
Do I really need to worry about this? Yes!
By now the wheels may be turning…you may be thinking: “Why do I need to pay myself any kind of payroll, that’s expensive right?”
Answer: Yes and No
Yes, paying payroll means that you are paying FICA taxes (Social Security/Medicare)
Also no, in that this is an IRS audit point in which the IRS can challenge your $0 payroll if they decide to audit you. The ramifications are very expensive if the IRS determines that some of your Shareholder Distributions are actually Wages. They can reclassify distributions and charge you late penalties and interest–which can get quite expensive very fast!
Not paying yourself is a risk that you take when the IRS has specifically said that you must pay yourself “Reasonable Compensation”. Ultimately, It’s up to you if you want to take that risk!
What constitutes as Reasonable Compensation?
Getting to this number can be confusing. And, you may want to pay yourself something unreasonable to save on payroll taxes–don’t do it and take this approach to figure out what Reasonable Compensation is for you.
Consider the following 3 approaches:
- Market approach
- Income approach
- Cost approach
The Market approach looks at the compensation being paid by those businesses to employees who are performing the same functions as you. The question becomes, how much should a company pay someone who does what you do, that isn’t related to your company?
The Income approach is less used because it is based on the independent investor test which leads to reasonable compensation being based on the fair market value of the company each year.
The Cost approach breaks your employee activities into individual components such as accounting, finance, management, advertising, etc. We actually like this approach for most S-corp owners with revenue of $500,000 or less. In this approach, you split out your duties and rate per hour for those duties. For example, if you spend 5 hours per week working on marketing and 20 on management, there’s no reason to pay yourself a higher wage for 25 hours if you’re only spending 20 hours on the higher-value activities.
Here’s an example of how this works:
| Task | Hours | Wage | Amount |
| Taxi driver and chauffeur | 104 | $12.75 | $1,326 |
| General manager | 624 | $58.32 | $36,392 |
| Wholesale buyer | 166 | $27.59 | $4,575 |
| Collections clerk | 146 | $15.32 | $2,237 |
| Sales representative | 624 | $30.96 | $19,149 |
| Order clerk | 416 | $18.56 | $7,340 |
| Totals | 2,080 | N/A | $71,019 |
You can also consider health insurance, pension, and other costs that get reported on the employee’s W-2.
Tax Planning
Reasonable compensation usually goes hand-in-hand with tax planning for the business owner. Since the net income of the company is passed through to the owner to be taxed at their personal tax rates, getting it as low as possible is what we’re after. However, paying yourself a higher wage to get more deductions has its limitations.
You will want to consider the following:
- FICA taxes paid on wages
- Section 199A Deduction (20% tax deduction on net income)
- Other tax strategies to acheive expenses that may be more useful than a higher wage
And there are many more that can come into play to achieve lower tax liability.
Take Aways
If you want your S-corp salary to hold up in an audit you should do two things:
- Make sure you documents your salary in your corproate minutes
- Have documentation to prove your salary is reasonable
Both you and the IRS have two viable approaches for determining your reasonable compensation:
- Market approach
- Cost approach
Whichever approach you use, if you have your reasonable compensation well documented then you can be confident that you’re in the “safe zone” of your reasonable compensation.
Of course, if you need help in figuring out your reasonable compensation don’t hesitate to reach out and ask!