What are the S Corp Payroll Requirements

Female S corp owner preparing documents for payroll

It’s easy to understand payroll for regular S corp employees. You pay the prevailing wage or better, give regular wage increases to those key employees that set you apart, and ensure they are incentivized to stick around. There are no requirements or IRS scrutiny around what you pay your people.

Paying a salary to owners working within the company involves a delicate balance. It’s essential for owners to establish a salary based on evidence. As a sole S corp owner, determining a reasonable wage entails considering the required experience and contributions to the company. Overpaying could result in personal income loss. Therefore, it’s crucial to pay only what is justified by these factors.

So, what is the role of corporate officers, what is reasonable compensation, what precedents exist, and how is all of this managed? Read on to learn how to pay yourself the right amount to keep you out of trouble with the IRS while preventing unnecessary expenses.

 

Determining Reasonable Compensation

 

When a corporate officer is also an owner [shareholder], it might be tempting to pay too little and save on payroll taxes or too easy to pay too much to be safe from IRS penalties.[1] A significant consideration must be “reasonable compensation” to save each owner money and stay compliant with the law.

Determining reasonable compensation isn’t always easy, but it comes down to several primary considerations. Those considerations include [2]:

  • Educational or experience requirements for the job performed
  • Equivalent pay with others in similar positions
  • The industry in which the company operates
  • Annual gross company earnings
  • Time in the position
  • Contribution to growth and growth rates

A CEO’s compensation should be aligned with their contribution to the company’s gross revenue. It’s neither advisable for a CEO to be underpaid significantly nor to be excessively compensated. Paying a CEO too little can attract IRS scrutiny while paying excessively can strain the company financially or result in higher personal payroll taxes for the owner.

When reasonable compensation is established, the company is better prepared with a defense in the event of an audit, and the owner can take distributions that are appropriate and not subject to employment taxes.

 

Legal Considerations and Court Precedents

When it comes to determining reasonable compensation for an S corp owner/employee, courts will typically consider [3] 1) the employee’s credentials and expertise, 2) the breadth and depth of their responsibilities, 3) the scale and intricacies of the business operations, 

s corp owner revewing employee files to check s corp payroll requirements

4) how their salary aligns with the company’s overall income 5) the prevailing economic climate 6) how salaries compare to distributions to stockholders 7) the company’s compensation practices for all staff, and 8) the employee’s historical compensation within the organization.

This calculation will continue to be a contentious topic as the term “reasonable” could have multiple determinations as to what it means. Over the years, the Treasury Department and courts have struggled to define “reasonable” without thoroughly clarifying what each position in different industries and corporate lifecycle should pay its executives.[3]

Naturally, these variables can be challenging to calculate, and the courts might produce different results from their considerations. An owner who comes with an expert opinion on reasonable compensation is well insulated from the disparate opinions of the courts and Treasury Department.

 

Refining Compensation Allocations: Distributions, Dividends, and Wages

 

Employment taxes are 15.3% of an employee’s wage, with 7.65% paid by the employee and 7.65% paid by the corporation. An employee-owner receiving reasonable compensation will only pay payroll taxes on their wages and receive distributions or dividends free of FICA taxes.

Though the company may claim a write-off from its payroll taxes, they are still unnecessary if the owner is overpaid or a threat when the owner is underpaid. Paying the right amount is a balancing act to prevent IRS scrutiny or avoid paying too much.

While the Social Security portion of payroll taxes (6.2% for both employee and employer) falls off when the employee makes $160,200,[4] the Medicare rate of 1.45% for both the employee and employer has no cap, and employers are responsible for an additional 0.9% in taxes for employees making over $200,000/year.

The process of determining the correct reasonable compensation is essential. Once fair compensation is established, dividends and wages beyond that amount are free from the 15.3% payroll taxes.

 

Ensuring S Corporation Payroll Compliance

A reasonable wage calculation is all it takes to ensure an S corp maintains payroll compliance, but determining a reasonable wage isn’t simple. Many factors come into play, and even the courts and the Treasury Department disagree on “reasonable.”

s corp owner reviewing charts and graphs going over past financials as part of ensuring payroll requirements as an s corp

When that reasonable wage calculation is provided by a company that specializes in determining reasonable compensation, the corporation is protected and ensured to be compliant.

Using RCReports, S corporation owners and accountants gain confidence in their ability to determine reasonable compensation while considering dividends and distributions. This helps them operate in compliance with regulations and avoid unnecessary payroll tax expenses. RCReports provide the assurance of finding the optimal reasonable compensation level.

Contact RCReports today to ensure your S corp is compliant and paying fairly.

Sources

 

1. Hamann, P. (2022, August 1). IRS Tech Targets S Corp Officer Compensation

RCReports. https://rcreports.com/blog/irs-tech-targets-s-corp-officer-compensation/

2. Hamann, P., & Salewski, J. (2019, December 1). Step by Step Guide: How to 

Calculate Reasonable Compensation. RCReports. https://rcreports.com/blog/how-to-calculate-reasonable-compensation/

3. Freeman, J. (n.d.). Clarifying the Contours of “Reasonable Compensation.” 

Freeman Law. https://freemanlaw.com/clarifying-the-contours-of-reasonable-compensation/

4. Topic No. 751, Social Security and Medicare Withholding Rates. (2023, October 

18). Internal Revenue Service. https://www.irs.gov/taxtopics/tc751

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