The tax savings of an S corp come from splitting profit into salary, which carries payroll tax, and distributions, which do not. That creates an obvious temptation to pay yourself as little as possible. The IRS knows this, which is why S corp owners who work in the business must take reasonable compensation.
What reasonable means
There is no formula or percentage in the tax code. Reasonable compensation is roughly what the business would have to pay someone else to do the work you do. The IRS has listed factors it looks at, including:
- Your training, experience and the duties you perform
- The time and effort you devote to the business
- What comparable businesses pay for similar services
- What the business pays non-owner employees
- The business’s history of salaries and distributions
Myths to ignore
- “The 60/40 rule.” There is no rule that salary must be 60% of profit, or any other fixed share.
- “Pay yourself nothing in a lean year.” If you are working in the business and taking distributions, a salary of zero is very hard to defend.
What happens if it is too low
The IRS can recharacterize distributions as wages, then assess the payroll taxes, penalties and interest that should have been paid. Courts have supported this when owners paid themselves far less than the market rate for their work.
How we set it
- Describe the roles you actually perform, and roughly how your time splits between them.
- Benchmark each role with market salary data for your region.
- Adjust for the business’s profit and ability to pay.
- Document the analysis and revisit it every year as the business changes.
Salary affects more than payroll tax
- QBI: S corp wages are not qualified business income, so a higher salary can reduce the 20% QBI deduction, although wages can also help owners above the income limits qualify.
- Retirement: Solo 401(k) employer contributions are a percentage of W-2 salary, so a very low salary limits how much you can put away.
The right salary balances all three. See how salary changes your savings in the S corp tax calculator.