What makes an S corporation (S-corp) salary reasonable depends on several factors, such as the type of work being done, business standards, and company profit. Setting a reasonable salary is important for operating an S-corp and also keeps the IRS from reclassifying your distribution and exposing you to penalties, interest, and additional taxes.
Key Takeaways
- There are several factors that affect whether a salary is reasonable, including the type of work, the person’s schooling, and the person’s work history.
- If the IRS determines that your pay is too low, then it can increase it by any distributions that were paid to the same shareholder/employee.
- A big red flag for the IRS is when there are owner distributions that are too low or there are nonexistent shareholder salaries.
Factors Affecting a S-corp Reasonable Salary
As a shareholder-employee, your salary should typically be proportionate with your responsibilities. You should take into account the following elements to decide if the wage you set is reasonable.
Hours Worked per Month
One of the biggest factors you should consider when setting a reasonable salary is the number of hours that you work during the month. Here are some things to consider:
- Is this the only job worked during the month?
- Does the job require an extraordinary commitment of time?
- Is the time commitment commensurate with the industry standard?
Education & Experience
If the shareholder-employee has relevant prior experience, education, or proven expertise in the area, a higher salary might be appropriate considering their academic or professional background. If the salary is too low, this may be a huge red flag for the IRS.
Industry & Competitive Pay
While a higher pay could be granted for services rendered, in general, reasonable compensation is the amount that would ordinarily be paid for services by similar corporations in the industry.
Earning History
Unless your duties as shareholder-employee change significantly, a notable increase or decrease in your salary may be perceived to be unreasonable. So, if you’ve been getting paid the same amount for a number of years, you shouldn’t make any drastic changes to your salary unless there’s a good reason for doing so.
Profitability of the Company
If your S-corp is new and you have yet to generate a profit by revenue, you might be unable to afford paying a reasonable salary—or even pay any salary at all. It’s fine to pay a low or no salary when the company isn’t profitable, as long as you’re not paying any dividend distributions during that time.
Back Pay
An S-corp reasonable salary can include back pay for years you were underpaid because of a lack of funds. Many S-corps might lose money in the first few years and not pay any salary to their shareholder-employees as a result. However, they can make up for that lack of compensation in future years when the company becomes profitable.
Given, track the years when the shareholder-employee was underpaid and when the salary was included as back pay. If there are years in which you paid a low salary because the corporation lacked funds, then you may have a higher-than-normal salary in a given year. Keep a record of this because any sudden change in your salary could trigger IRS scrutiny.
Expert Tip from Tim Yoder, CPA: The IRS is on the lookout for S-corps that are paying low salaries to shareholder-employees while also making dividend distributions. This could show that the S-corp is avoiding payroll taxes by disguising salaries as dividends. Generally, the IRS isn’t concerned with salaries being too high for S-corps.
Why Does an S-corp Reasonable Salary Matter?
The split between salaries and distributions matter because salaries are subject to payroll taxes and distributions are not. Quite often, S-corps try to disguise payments for services as distributions to avoid paying payroll taxes.
This is why it’s important for both the S-corp and the shareholder-employee to ensure that the shareholder-employee is paid a reasonable salary for services they provide. This protects both parties from taxes, penalties, and interest.
If you need help setting up a payroll system to process your salary, take a look at our guide on how to do payroll for small businesses.
Consequences of Setting the S-corp Salary Too Low
If the wages that you set are too low in a year where you’ve also made shareholder distributions, the IRS could reclassify your distributions as salary and assess payroll taxes plus penalties and interest. If there are multiple shareholders, this reassignment of distributions causes uneven distributions. This creates two classes of stock, which could cause the revocation of the S-status. You can learn more about this and other restrictions on S-corps in What is an S-Corp?
Consequences of Setting the S-corp Salary Too High
While the IRS may not care if your S-corp shareholder salary is too high, you’ll end up paying more payroll taxes than needed. Setting a reasonable salary is a balance between ensuring enough salary is paid to avoid the reclassification of shareholder distributions and minimizing the amount of payroll taxes paid.
Frequently Asked Questions (FAQs)
Yes, it does. If an S-corp generates profit, then it must pay its employee-shareholder a reasonable salary. However, if the income the S-corp generates is low, then the salary paid may reflect this.
Yes, S-corps have to pay payroll taxes for their employees, including their shareholders who perform services for the business. The S-corp is responsible for withholding the employee’s share of FICA taxes from their wages and paying its share of FICA taxes on behalf of its employees
Yes. If the IRS determines that your shareholder salary is unreasonable, then you could face an IRS audit where the burden of proof will be on you to establish that your salary is reasonable. A particular red flag to the IRS might be having a low salary at the same time as paying shareholder distributions.
Bottom Line
A reasonable salary is how much an employee or company officer should get paid for the work they do, taking into account things like their job duties, responsibilities, qualifications, and industry standards. It’s important to ensure that a salary isn’t too low so that the IRS can reclassify shareholder distributions as wages.
This can not only create payroll taxes and penalties, but it might also automatically revoke your S-election if you have multiple shareholders. The IRS may look into rates that seem too low compared to industry standards or to how well the company is doing financially.
