No one likes to pay more in taxes than they have to. The desire to minimize taxes makes S-corporations a great choice for many small businesses. Like all pass-through entities, net income of an S-corp is passed through to the owners to be taxed on their personal tax returns.
But unlike sole proprietorships and the active partners of partnerships, this net income isn’t subject to self-employment taxes, which can lead to substantial tax savings. Self-employment taxes are currently levied at 15.3% up to the Social Security limit of $127,000 and at 2.9% above that.
S-corp shareholders are considered employees of their corporation and are paid a salary. Cash distributions to shareholders are split into two buckets: tax-free distributions and wages, which are subject to payroll taxes.
This split motivates many shareholder-employees to maximize their cash-free distributions and to minimize their wages. Not surprisingly, the IRS frowns on this and has a history of reclassifying distributions as wages. If your distributions are reclassified as wages, you’ll owe back payroll taxes plus penalties and interest.
The IRS requires that shareholders receive “reasonable compensation” for their services. Reasonable compensation isn’t defined in the regulations. Instead, the IRS and courts rely on a series of factors to be considered when they look at compensation levels.
In most situations, a portion of the distributions a shareholder receives should be classified as wages. Here are five factors used by the IRS and the courts to evaluate whether compensation is reasonable.
1. Nature of the business
How does your business make money? There are three general sources of gross receipts for a company:
• Services of the shareholder
• Services of non-shareholder employees
• Capital and equipment
2. Qualifications of the Employee
The experience and training, duties and responsibilities and time and effort required for the shareholder will also be considered. The whole picture of what you do — from administrative and clerical work to highly technical and specialized tasks will be included. Higher levels of expertise and effort translate to higher salaries.
3. Compensation of Other Employees in the Business
A shareholder with extensive experience in the field should be paid more than recent college graduates. A 2012 case, Watson, 107 AFTR 2d 2011-305, made this clear. David Watson, a CPA and the sole shareholder of his accounting firm S-corp, paid himself $24,000 in salary, while taking between $175,000 and $204,000 in distributions. He paid his newly graduated employees more than that. Applying salary surveys for comparable positions, the IRS determined that reasonable compensation for Mr. Watson was $91,044.
4. Salaries for Comparable Services
Benchmark studies of comparable salaries, such as on salary.com, indeed.com, monster.com, and specialized industry surveys can be useful sources of guidance. However, many S-corp shareholders wear multiple hats in their businesses, and their duties can include everything from sweeping floors to high-level consulting work. Tracking the time you spend on various duties and applying the resulting ratios to market pay rates for each of those job classifications can provide a more accurate number for your salary.
5. Ratio of Compensation to Profits
A small company in the same industry as a Fortune 500 company most likely won’t have the same budget for executive pay. Using ratios such as those found in the Risk Management Association’s Annual Statement Studies can be useful in adjusting your compensation to an appropriate percentage of profits
Consideration of these factors will help you determine the appropriate level of compensation for your S-corporation. We recommend documenting this analysis in the company minutes and updating this calculation on an annual basis. Documentation can be crucial in case of an IRS audit.
Do you need help determining reasonable compensation for your S-corporation? Contact our office at 561-624-2118 and we’ll help you set the right compensation for your business!