The reason most small businesses elect S Corporation status is simple: owners who work in the business can split their earnings between a salary and distributions. Salary is subject to payroll taxes; distributions generally are not. That split only works if the salary is reasonable.
What the rule requires
When an S Corporation owner performs services for the business, the IRS expects the company to pay that owner reasonable compensation as wages before taking distributions. If an owner takes little or no salary and large distributions, the IRS can treat some of those distributions as wages and assess payroll taxes, interest and penalties.
What “reasonable” means
There is no single formula. The question is what the business would have to pay someone else to do the same work. Factors commonly considered include:
- The owner’s training, experience and duties.
- The time the owner devotes to the business.
- What comparable businesses pay for similar services.
- The company’s revenue, profit and ability to pay.
- How much is paid to non-owner employees.
- Any history of salary versus distributions over time.
An owner who runs the business full time and generates most of its revenue will usually need a meaningful salary. An owner who works part time, or whose profit comes largely from employees and equipment, may justify a lower one.
Common mistakes
- No salary at all while taking regular distributions.
- A salary chosen once and never revisited as the business grows.
- Personal expenses run through the business instead of being paid as compensation or distributions.
- No documentation of how the number was set.
How to set and support the number
- Describe the owner’s actual roles and hours.
- Compare pay for those roles using salary data for your area and industry.
- Consider the company’s profit and cash flow.
- Write down the reasoning, and keep it with the company’s records.
- Review the salary at least once a year, ideally before year-end.
It connects to the rest of your planning
The salary also affects retirement plan contributions, the qualified business income deduction and Michigan income tax planning, so it is best set as part of a broader plan rather than in isolation. If the business has more than one owner, the operating agreement or shareholder agreement should match how owners are actually paid.
Because the election, the payroll and the governing documents all have to line up, this is an area where having an Attorney and CPA in the same place helps. Learn more about tax planning.
This article is general information, not legal or tax advice for your situation. Reading it does not create an Attorney-client relationship.