S Corp Salary 50/50 Rule: A Complete Guide

S Corp president and a share holder walking and talking in the office discussing the 50/50 rule for salaries

Many S corp owners working in their business question how much they should pay themselves as an employee of the company before taking their distributions. Unfortunately, many business owners and accountants are misinformed about calculating reasonable compensation, preferring to adopt old myths that potentially hurt the business owner financially.

This article will discuss the 50/50 rule, why it is an incorrect myth, and how to accurately think about reasonable compensation.

What Is the 50/50 Rule for S Corp Compensation

The 50/50 rule refers to dividing up an S corp owner’s pay and distribution structure with 50 percent going to salary and the other 50 percent to owner distributions. This rule has generally been applied as a way to define “reasonable compensation” that the IRS wouldn’t question.

Over time, this rule has become so pervasive that even 33 percent of accountants believe it to be true.

The problem is that reasonable compensation isn’t defined as a specific percentage of earnings.

How does the S Corp 50/50 Rule Affect Salaries and Distributions

For an S corp owner working in the business, taking 50 percent of earnings as a salary means the payroll taxes are paid on those funds, whereas no self-employment taxes need to be paid on the remaining distributions.

If the company has earned $200,000 this year, $100,000 would have gone to the owner in the form of compensation and be subject to payroll taxes, which would be a total of 15.3 percent, with half paid by the company and the other half taken from the owner’s paycheck. Social Security payroll taxes will be paid at a rate of 12.4 percent until a wage base limit of $160,000, and Medicare taxes paid at 1.45 percent with no limit and an extra 0.9 percent taxed when wages go over $200,000.

Distributions, or pass-through income, will still be subject to state and federal taxes, not self-employment taxes.

Other Common Wage To Distribution Ratios

The two other most common ratios would be 60/40 and 40/60 splits, with either 40 percent or 60 percent going to salary. Just like the 50/50 ratio, there is no predefined percentage split that defines reasonable compensation, and these rules aren’t necessarily correct.

share holders working together

Are S Corps Required to Pay Salaries to their Shareholders

If an S corp has multiple shareholders, but many aren’t actively working in the business, it is not required to pay them a salary. Those shareholders will receive distributions that are not subject to self-employment taxes.

If a shareholder works in the company, they must pay themselves a reasonable wage for their functions and have payroll taxes deducted from their paychecks. Fortunately, the company’s portion of the payroll taxes is a tax write-off.

Determining a Reasonable Salary for Your Shareholders

If a shareholder works within the business, they must be paid a salary that is equivalent to the level of expertise, amount of work, and position in which they work. Some considerations when determining what is a reasonable salary would be:

  • Duties and responsibilities
  • Training or required experience
  • Amount of time and effort dedicated to the business
  • Compensation agreements
  • How bonuses are paid to key people
  • Industry

If the shareholder is working 60 hours a week as the company’s president and the job requires specific knowledge or skills, that owner needs to ask how much would be paid to someone else to assume that position. If the shareholder is doing a $100,000 per year job, paying themself $24,000 per year would be inappropriate, whereas paying themself $200,000 per year would result in excessive employment taxes being unnecessarily paid.

Should the IRS find the shareholder is deliberately underpaying themself, it could assess taxes to be paid on what would be considered the reasonable salary plus potential fines and interest.

S Corp Reasonable Salary Examples

Reasonable salary comes down to the job requirements and specialized skills or education required but also considers the amount of money the company makes. Should the company only make $20,000 annually and the S corp shareholder works 40 hours weekly, the owner would take all profits as a salary.

Should the company make $5 million per year, it would be unnecessary for the shareholder/employee to use the 50/50 rule if reasonable compensation for someone in their role is $250,000/year. Paying compensation of $2.5 million a year means far too much is being paid in payroll taxes.

Let’s say one shareholder works in the business full-time as a receptionist, whereas the other shareholder works as the company president. Compensation for each must be calculated as what would be paid when hiring an employee for that position. For instance, a company’s president’s compensation might align with an annual salary of $100,000, reflecting a higher pay scale within the workforce, whereas the receptionist’s compensation could be set at $40,000.

In this example, if both shareholders receive another $100,000 in distributions, they only pay payroll taxes on their reasonable salaries.

Identify the Best Way to Pay Yourself as an S Corp Owner

S Corp shareholders celebrating

It might seem somewhat speculative when determining what is reasonable compensation, but there are real-world examples of what people are paid in similar positions. The best information for reasonable compensation might be using a job website to see what companies offer others for similar education, experience, industry, and responsibilities.

While even some of the most authoritative sources will quote the 50/50 or 60/40 rules, they could set you up to over or underpay yourself. Don’t use a rule that could cost you when you could pay yourself what is similar to others in the industry.

RCReports is used by accountants, business valuators, attorneys, and business owners to determine reasonable compensation for S corp shareholders across all industries. Using RC Reports keeps business owners out of trouble with the IRS and ensures they aren’t paying unnecessary payroll taxes.

Sign up for a demo with RCReports today and skip using the incorrect rule of thumb.

References

  1. Fishman, S. (2023, October 21). What is an S Corp “Reasonable Salary”? How to Pay Yourself the Right Way. Collective Hub. https://www.collective.com/blog/money-management/freelancers-guide-to-paying-yourself-a-salary-from-an-s-corporation#:~:text=A%20commonly%20touted%20strategy%20to,and%2050%25%20in%20profit%20distribution.
  2. Massey, G., CPA. (2023, September 15). Reasonable compensation, payroll and distributions for an S Corp owner. Massey and Company CPA. https://masseyandcompanycpa.com/what-is-reasonable-compensation/
  3. Wage Compensation for S Corporation Officers. (2008). Internal Reveue Service. https://www.irs.gov/pub/irs-news/fs-08-25.pdf

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