What is the S-Corp 60/40 Rule?

Shareholder meeting to discuss the S-Corp 60/40 split for salaries

One of the most important questions facing S Corp owners is how they should compensate themselves. Particularly, they have to determine how much they should pay themselves as a salary before their distributions. A salary that is too low could trigger problems with the IRS, whereas too high of a salary could result in the payment of unnecessary taxes.

 

Understanding S Corp Salary Strategies

 

S Corp salary strategies have been created as a way to ensure the owners pay themselves a reasonable salary as mandated by the IRS. Active owners of S Corps with greater than 2% ownership realize the benefit of not having to pay payroll taxes on their distributions so long as they pay themselves a reasonable salary from which payroll taxes are taken.

Reasonable salaries are wages that account for many variables, including:

  • The required training and experience
  • Time spent working within the business
  • What comparable businesses pay for similar positions
  • The position’s duties and responsibilities
  • Salaries paid to non-shareholder employees
  • The company’s dividend history
  • The geographic location of the business 

As it can be difficult to determine a reasonable salary, many S Corp owners and their CPAs have come to rely on salary rules that can be overly arbitrary in their application and might create unnecessary costs or trigger IRS audits.

These strategies specify a percentage of earnings to be paid as salary, leaving the remaining percentage to be paid out as distributions. Typically, such strategies specify a 60-40 or 50-50 split between salaries and distributions.

 

The 60/40 Rule S Corp Approach: A Closer Look

 

The most common strategy used to specify the amount of earnings paid in salary and distributions is the 60-40 approach. Under this strategy, the owner would pay themself 60% of earnings as a salary and the other 40% as distributions. [1] That percent split is applied regardless of the company’s earnings, which makes it easy and often advised by accountants and other sources, but also problematic.

One of the main issues of such a profit/dividend split is the difference in salary for a company that earns $60,000 a year and one that earns $1.5 million. Using the split, one owner would be underpaying themself while the other is potentially being paid an excessive salary and spending an unnecessary 15.3% on payroll taxes beyond what they should pay.

Another problem is that the owner might wear many hats and perform different jobs in the company. Some have an expected lower salary requirement, and others have a higher reasonable compensation amount. A salary/dividend split doesn’t take the differences in reasonable salary per job performed into account.

Some other issues that come into play would be when a salary can be reduced because:

  • The business is less profitable than similar entities
  • The owner works part-time
  • The success of the business isn’t solely from the owner’s efforts and other factors like assets or employees are considerable contributors.

 

Application of 60-40 vs 50-50 Rule

A simpler application of how to split profits between salary and dividends is the 50-50 rule. If the business nets $10k for the month, the business owner simply pays themself $5,000 and leaves the other $5,000 for dividends. [2]

shareholder meeting, a man stands ahead of the confrence table pointing to a chart explaining the 60/40 split

Again, this is a simplified approach that even neglects that many of the funds left within the company might go towards reinvestment and reduce the company’s taxable income and dividend payouts. In too many cases, these percentage applications have been thrown out of court when the IRS has sued.

Both rules are applied identically other than the percentage split, which means both are deficient when it comes to considering the status and income of the company and what should account for the actual requirements for reasonable compensation. Again, whether company income is very high or low, applying these rules equally is unreasonable

Unfortunately, such simplified rules have even been espoused by major firms and institutions due to their inability to properly define reasonable compensation for individual positions. They are providing advice that has the potential to put companies at risk of IRS audits or unnecessary payment of payroll taxes.

 

Navigating the Nuances of S Corp Compensation

 

With an absolute lack of information as to reasonable compensation, the best thing an S Corp owner might be able to do is utilize one of the general rules, but the owner is now at risk of under or overpayment of payroll taxes. The end result of either happening is an unnecessary cost.

Should the S Corp owner want to be safe and prevent the over or underpayment of payroll taxes due to an incorrect salary/dividend split, that owner needs to weigh geography, educational and experience requirements, salaries at similar firms, their disbursement of duties performed daily, the company revenue, exigent factors that might account for company success, time worked in the business, and the salaries and bonuses of non-shareholder employees.

To say that there are tremendous nuances to navigate to define accurate compensation for S Corp owners might be an understatement. The 60-40 and 50-50 rules might open up tremendous jeopardy of over or underpayment of expensive payroll taxes but determining reasonable compensation using the plethora of factors that come into play can be incredibly difficult. Even a company’s accountant might not know how to get the equation right.

 

Using Experts To Determine Reasonable Compensation Saves S Corp Owners Money

shareholders shaking hands after agreeing on the 60/40 rule

The salary/dividend split has tremendous potential to work out poorly for S Corp owners. It is commonly referred to as a rule of thumb when other organizations just don’t have a better answer.

Based on the earnings and specific circumstances of an S Corp, a percentage split approach could put S Corp owners in jeopardy of an IRS audit that results in penalties and fines or a substantial overpayment of 15.3% payroll taxes that is totally unnecessary. [3]

Should owners turn to attempting a reasonable wage calculation based on the multiple variables involved, they have a chance of getting the calculation right and many ways to get it very wrong. The best thing they can do to protect themselves from the IRS is to document what went into the calculation and hope they’re close.

For a business or CPA wanting the most accurate calculation of reasonable compensation based on industry, position, educational requirements, location, and company earnings, turning to a firm that specializes in ascertaining reasonable calculation is the best way to ensure the calculation is correct.

Companies with experience evaluating reasonable compensation for S Corp owners across industries ensure that payroll taxes are neither under nor overpaid.

RCReports expertly analyzes and determines reasonable compensation for companies based on all of the relevant variables. Accountants use them to ensure they are providing their S Corp owner clients with the highest levels of service and the best balance of compensation versus dividends to save their clients money.

Book a demo with RCReports today to unlock the cost and risk savings of utilizing accurate, reasonable compensation.

Sources

 

  1. Reasonable Compensation and S Corps: A Guide for Small Business Owners. (2023, September 26). Block Advisors. https://www.blockadvisors.com/resource-center/manage-your-business/s-corp-reasonable-compensation
  2. 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
  3. Publication 334 (2023), Tax Guide for Small Business. (2023). Internal Revenue Service. https://www.irs.gov/publications/p334

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