S-corp shareholder-employees must pay themselves a reasonable salary and remit the corresponding federal self-employment taxes or risk heavy penalties from the IRS. Determining a reasonable salary for S-corporation shareholders who work for the company is just one of the many financial decisions you as a business owner will have to make in the early stages of your business.
Profits generated by an S corporation are passed through to the shareholders and are not taxed separately at the corporate level, meaning S-corp owners sidestep double taxation. They are also not obligated to pay self-employment taxes on dividends received. This is one of the major attractions of this business structure. However, taking too little in “wages” and too much in “dividends” to reduce one’s self-employment tax burden is illegal and is a major red flag for the IRS, which is why it’s critical for all shareholder-employees to be compensated appropriately.
S-Corp Distributions vs Salary
S-corp business entities must pay wages to any shareholders who are corporate officers or perform more than minor services for the corporation. This ensures that shareholder-employees pay the same FICA and FUTA taxes that would be paid on their behalf if they worked for someone else, and helps to prevent tax avoidance.
Some business owners may choose an S-corp tax filing status because of the potential tax advantages it can offer. If you currently have an LLC and your total net income is higher than a reasonable salary for someone in your position, you might benefit from S-corp filing. An accounting firm that offers S-corp CPA services can help you determine whether your company qualifies and whether this filing status would be advantageous for you.
S-Corp Distributions
Once salaries have been paid out, the business can then distribute the rest of the profits. These distributions are paid out as dividends to its shareholders. Because the distributed profits are “passed through” to the shareholders, they aren’t subject to a separate corporate tax, therefore avoiding double taxation to shareholders. This isn’t the case in some other business structures like C corps which are subject to double taxation on company profits.
What Is a Reasonable Salary for an S-Corp Shareholder-Employee?
The salaries of S-corporation shareholder-employees are a subject of great interest to the IRS. This is because the nature of an S corp allows shareholder-employees to pay Social Security and Medicare taxes only on the portion of their earnings that is counted as wages and not on the total amount they receive from the company. The IRS therefore has a system in place to rigorously check if the salary paid to an employee is reasonable and ensure that individuals aren’t avoiding self-employment taxes by paying themselves dividends instead of wages.
Start With Industry Standards
Though the IRS has a vested interest in examining how much S-corp employees are paid, it doesn’t provide specific rules for businesses to follow. In fact, regulations surrounding S-corp reasonable compensation are rather vague. Researching the average salary for a person in your position within your industry could be a good indicator of a reasonable salary.
How to Calculate Reasonable Compensation
When determining your or others’ salaries, it’s important to factor in everything the IRS would consider. This includes:
- Earnings
- Profits
- Your role
- Industry averages
Taking these factors into account may lead you to a ballpark amount. However, salaries are contingent on other factors as well. You should consider things like years of experience, training, qualifications, and any special expertise each employee offers.
The S-Corp Salary 60/40 and 50/50 Rules
There are two common rules that many S corps use to calculate salaries. Though these rules are common and popular ways of calculating salaries, bear in mind that they are only guidelines to come up with an initial figure and are in no way approved as calculation methods by the IRS.
S-Corp Salary 60/40 Rule
The S-corp salary 60/40 rule suggests owners pay 60% of profits to themselves as a salary and distribute the remaining 40%. For example, if a one-person S corp earns $100,000 annually, the owner would pay him or herself $60,000 in wages and take $40,000 as dividends.
The 50/50 Rule
Alternatively, splitting the profit evenly between salary and profit distribution can be a clean way of determining your salary.
Use the 60/40 and 50/50 Rules With Caution
If you use either the 60/40 or 50/50 rule as a basis for your salary propositions, be aware that your final salaries must satisfy the IRS. These rules may help some businesses, but sole reliance on these rules may lead to under or overpayment of self-employment taxes and potential penalties for lowballing your wages.
Another potential pitfall of using these rules is that every salary should reflect typical compensation for the role in question in your industry. The 60/40 and 50/50 rules don’t always align with industry standards and your estimates may need to be adjusted.
How Do S Corporations Run Payroll?
S-corporation shareholder-employees must calculate income taxes, self-employment taxes (FICA taxes), and unemployment taxes (FUTA taxes). The calculation will be based on each individual’s income during the calculation period.
While S corps have to run payroll as any other business does, there’s more flexibility than there is in some other business entities. This is especially true if there is only one shareholder-employee. In this case, the owner can choose to pay him or herself in several small payments followed by a larger end-of-year bonus.
Which Taxes Do S-Corps Need to Pay?
Your S-corp salary, just like any other, is subject to several taxes. Be aware of the different taxes you must pay on your personal tax return:
- Self-employment taxes (FICA taxes): 15.3% of each employee’s wages
- Federal unemployment tax (FUTA tax): 6% on the first $7,000 of the employee’s wages
- Shareholders (regardless of whether or not they are also company employees) must pay income taxes on their earnings. The federal marginal tax rates for the 2023 tax year are between 10% and 37%.
How Do S-Corp Owners Pay Themselves?
Apart from calculating reasonable compensation for yourself and any other shareholder-employees, it’s essential to stay on top of the practical side of payroll and tax filing.
Follow these steps to pay yourself and any other shareholder-employees:
- Pay yourself and other shareholder-employees a reasonable salary, staying compliant with IRS regulations. Calculate and withhold the corresponding payroll taxes.
- Record all payroll transactions.
- File federal quarterly payroll taxes.
- File state payroll taxes.
- Prepare and file your annual individual and business tax returns (both federal and state).
Working with a CPA is advantageous as they will understand the taxes you are subject to as a shareholder-employee. They can also help you stay up to date with payment and filing deadlines to minimize the likelihood of penalties for late payments.
S-Corp Salaries Must Be Fair
Starting a new business can be a challenging, exhilarating, and exciting time, and sometimes it’s easy to feel overwhelmed. Knowing that you’re making compliant and sound business decisions for your S corp can give you peace of mind as well as potentially save you money on hefty IRS penalties down the line.
That’s where experienced CPAs at a trustworthy accounting firm come in. Experts who offer S-corp CPA services can help you determine reasonable compensation and lay down all the necessary foundations for your S corporation to thrive.
