A reasonable salary is the portion of your compensation that should be treated as wages. S Corporations must pay payroll taxes (Social Security and Medicare) on salaries paid to employees.
Many S Corp owners attempt to minimize their salary to avoid self-employment tax. This can lead to IRS scrutiny and potential audits.
What Is a Reasonable Salary?
A reasonable salary is an amount an S corporation owner-employee should receive to cover the cost of the services they provide the business. In addition, the owner-employee should be paid at most the amount the company could pay another employee for the same work.
Many S corporation owners choose to pay themselves a salary versus taking distributions from the business because it saves them on payroll taxes. However, the IRS has a close eye on how S corporations divide their income into salaries and shareholder distributions to catch companies attempting to avoid paying payroll taxes.
To avoid being fined by the IRS for failing to pay payroll taxes on the owner-employee’s compensation, S corporations must ensure that all owner-employees receive a reasonable salary. Otherwise, the IRS can reclassify distributions received from the company as wages, which are subject to employment taxes.
The first step in determining a reasonable salary is determining what similar companies typically pay their employees. This can be done using salary analysis reports or by researching websites such as the Bureau of Labor Statistics.
The next step is to consider your facts and circumstances. Sometimes, it may be best to hire a professional to help you determine your reasonable salary.
How Do I Determine a Reasonable Salary?
If you’re an S corporation owner, you may wonder how to determine a reasonable salary for S corp. This is crucial in ensuring you remain above board with the IRS while reaping the tax savings of running your business as an S corporation.
To determine a reasonable salary, you must pay attention to what other businesses pay for similar services and what you expect to be paid in the same role. It would help if you also considered your time and effort devoted to the business.
The IRS deems a reasonable salary to be the amount that other business owners in your field would be paid for similar duties. This can be determined by leveraging third-party research to determine what others in your area earn.
You can use the Bureau of Labor Statistics website to learn about salary information for various jobs. This website is free and includes detailed salary information for hundreds of positions.
Once you’ve found a number that feels reasonable, divide it by the number of pay periods (monthly, quarterly, etc.). This will be the basis for calculating your income and FICA taxes.
You should also remember that if you fail to pay your payroll taxes, you can face severe penalties and fines from the IRS. This is especially true if you try to hide your salary with distributions you take from the business.
How Do I Determine if My Salary is Reasonable?
An S Corporation is a tax structure that allows small business owners to save on Social Security and Medicare taxes. However, it has become a hot-button issue between the IRS and taxpayers.
As a result, the IRS has stepped up its scrutiny of salary versus distributions with S Corp employees. Fortunately, there are many ways to determine reasonable compensation.
First, look at what other employees are earning in your field. Then, consider your own company’s unique situation.
Another factor to take into account is how you plan to pay yourself. For example, if you have a high net worth and plan to put most of your profits into your retirement account, paying yourself a higher salary than other employees in your industry may make sense.
You can also use the Bureau of Labor Statistics to find the average salaries for similar jobs. You can find this information accessible on the website.
Finally, you can hire an accountant to help you determine your reasonable salary. You can also seek a payroll tax service to handle your S Corporation tax return for you.
Ultimately, the IRS looks at these factors to determine reasonable compensation. No single factor controls; it is a preponderance of the evidence.
What Happens if My Salary is Determined to Be Unreasonable?
If your salary is unreasonable, it can result in the IRS reclassifying some or all of your distributions as wages. You will have to pay back payroll taxes and any penalties the IRS imposes.
If you are a shareholder-employee, consider the salaries of other employees who perform similar work and have the same experience levels. The courts will weigh these factors when determining reasonable compensation for an S corporation.
Another consideration is the labor burden rate. This rate can vary from 1.4 to 2.0 and affect your tax liability.
When calculating the labor burden rate, it is essential to consider the time and effort you put into your job and the amount of work you do each day. In addition, your level of education should be taken into account.
For example, the IRS will likely question your salary practices if you are a CPA with substantial experience in your field and you hire a recent college graduate to work for you.
An S corporation owner’s salary is one of the most critical issues that the IRS examines. As a result, the IRS is rigorous when discussing S corporations’ wages.