What is a Reasonable Salary for an S Corp Shareholder?

woman s corp owner reviewing payroll and salary for her business

When you register your business as an S Corp, it comes with some outstanding tax benefits and protections for an owner, including reduced self-employment taxes, pass-through income, and shareholder liability protection. However, benefits often come with some caveats, in this case, more stringent requirements to maintain the S Corp’s legal status and tax benefits. One of the most important concerns is that owners working within the company pay themselves a reasonable wage.

Beginning to Understand S Corps & Payroll

Knowing why an S Corp reasonable salary requirement matters is crucial to best understand the S Corp payroll benefit.

Importance of Reasonable Salary for S Corps

S Corps offer shareholders with greater than 2% ownership and who work actively in the company the incredible benefit of not having to pay 15.3% payroll taxes on their distributions. To realize this benefit and not risk an IRS audit or overpay unnecessary taxes, the owner/employee must be paid a reasonable salary.

A reasonable salary often depends on a variety of factors, including the educational requirements of the position, work hours required, mix of duties, comparable wages in the industry, and company earnings, just to name a few. The need to account for and weigh so many factors means that determining reasonable compensation is not a straightforward task.

To best protect the business and its shareholders from the IRS or employment tax overpayments, what seems at times arbitrary needs to be documentable with solid evidence for that salary.

S Corp Distributions Vs. Salary

With the correct salary calculations, an owner pays themself not too little or too much, meaning that additional earnings taken as distributions are free of the expensive 15.3% self-employment tax. If too little salary is taken, the company is at risk of an audit that could result in costly penalties and interest. If too much compensation is paid, additional, unnecessary employment taxes are paid by both the employee and the company.

The best strategy is to pay yourself commiserate with what would be considered a reasonable wage for what you do, contribute, and the job requirements.

How Do S Corp Shareholders Pay Themselves?

S Corp shareholders with more than 2% ownership of the business will pay themselves a reasonable salary on a W-2, just as they will pay all other employees. For all intents and purposes, each owner in such a capacity is functioning as an employee of the company. [1]

an s corp owner scanning a check for desposit through her phone paid out by her business

The key is ensuring the right salary is paid, hitting the sweet spot of neither too little nor too much.

Factors in Setting a Reasonable Salary

As mentioned previously, calculating a reasonable salary involves many factors. Some of the most important are: 

  • Industry standards
  • Company earnings
  • Required level of education
  • Duties performed
  • Hours worked
  • The pay of subordinates
  • Years of experience
  • Earnings levels in that geographical area
  • Company contribution to the bottom line
  • Employee benefits offered

These factors can be as complex as calculating the value of the jobs performed if the owner wears many hats. For instance, time spent working as the CEO or CFO is more expensive than the hours spent taking on necessary clerical duties. Each needs to be accounted for individually.

If subordinates are paid equal to or more than the owner acting as president, that would be a tip-off to underpayment.

Also, if the owner is doing a job that would usually be done by an MBA but doesn’t possess such a degree, rather tremendous experience, that could also create problems in calculating reasonable compensation.

Industry matters tremendously. A CFO for a smaller construction company might be compensated differently than a similar position at a tech startup.

If the company makes $1 million a year or $20 million a year, it is reasonable to expect that the wages paid for similar positions could differ.

Reasonable compensation isn’t always easy to estimate. 

Calculating S Corp Salary: What to Consider

When calculating an S Corp salary, two initial questions start the process. They are:

1) “If someone else were in this position, would they consider this wage far too low?”

2) “Were another person acting in this capacity would other owners feel that person overpaid?”

From there, the best guide is finding out what similar positions are paying within your industry. That fosters another essential question, “If I were to post an employment ad for someone to fill my shoes, what would be a fair wage that someone would accept and take the job without being overpaid?”

These are basic questions to get started, and all factors included in the calculation need to be documented and explained as to how the owner came to the conclusion that their wage is reasonable.

Frequently, the easiest and safest way to accomplish what seems like a challenging task is to turn to experts who have done the calculations and have the documentation to back it all up.

Deciphering the 60/40 Rule for S Corp Pay

s corp business owner researching the 60/40 rule in regards to reasonable salary

Commonly used as a rule of thumb by many business owners and CPAs is the 60/40 rule, which specifies that 60% of earnings are paid to the owner(s) salary with 40% left for distributions. The problem with this rule is that it is based on earnings, which could leave an owner very under or overpaid. [2]

If the company stands to net $50k, it is safe to say the position of president is worth more than $30,000. In the inverse, should the company make $1 million during a banner year, $600,000 could be far higher than reasonable.

While simple to calculate, this rule has the potential to be very wrong.

Reporting Considerations

When reporting salary or distributions on your tax returns, they will be done so very differently.

S Corp Salary Reporting on Taxes

An S Corp owner’s salary is paid on a W-2, just like any other employee in the company; therefore, it will be shown as wages on the first page of your 1040. That part of your tax reporting is identical to anyone else working in your employ.

S Corp Shareholder Distribution Reporting

Distributions from an S corporation to its shareholders are a different matter and are reported by the owners of a company that has taken profits above their salary. To report the owner’s distributions, they will use Schedule K-1 (Form 1120-S), which the shareholder uses to complete their personal tax return.

Knowing Reasonable Compensation Is Essential

There is a lot on the line when it comes to reasonable compensation. Too little could trigger an audit and fees and penalties, while too high of compensation costs owners unnecessary money. It pays to get it right the first time.

RCReports specializes in reasonable salary calculations for S Corp owners. Regardless of position, time commitment, educational requirements, or industry, RCReports provides the data with backing that keeps S Corps from absorbing higher risk due to a miscalculation.

Whether you’re a CPA or owner, contact RCReports today and skip the salary guessing game.

Sources

1. TurboTax. (2024, March 14). Should I Pay Myself a Salary as an S-corp Owner? https://ttlc.intuit.com/turbotax-support/en-us/help-article/corporation/pay-salary-corp-owner/L9ey8xuIc_US_en_US

“Salary, including health insurance and other fringe benefits for officers or shareholders owning more than 2% of the corporation’s stock, should be included on the shareholder-employee’s Form W-2.”

 

2. Javed, R. (2023, October 24). Reasonable Compensation S Corp Calculator Online. CalculatorsHub. https://calculatorshub.net/financial-calculators/reasonable-compensation-s-corp-calculator/

Based on this rule, S-Corp owners pay themselves 60% of the profits as salary and the remaining profits can be distributed as dividends that are not subject to self-employment taxes.”

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