One of the biggest advantages of operating as an S corporation is the potential to reduce certain employment taxes. But that tax advantage comes with an important rule: if you work in your business, you generally can’t simply take all the profits as distributions. You need to pay yourself a reasonable salary for the work you perform. That sounds straightforward until you get to the obvious question: How much is reasonable?

Unfortunately, there isn’t a universal salary amount or percentage that works for every business. Determining S Corp reasonable compensation depends on your role, your industry, the financial condition of your company, and several other factors. Here’s what small business owners should know before deciding what to put on their own W-2.

S Corp Reasonable Compensation Defined

If you are both a shareholder and an employee of your S corporation, the IRS expects you to receive wages for the services you provide to the company. This becomes especially important when you’re taking distributions from the business.

Why? Because wages are generally subject to employment taxes. S corporation distributions generally are not subject to those same employment taxes. That creates an incentive for an owner to pay themselves a very small salary while taking most of the company’s earnings as distributions.

The IRS is well aware of that incentive. If your salary is unreasonably low compared with the work you perform, the IRS may reclassify some of your distributions as wages. That can result in additional employment taxes and potentially penalties and interest.

The goal, therefore, isn’t to find the lowest salary you can possibly justify. It’s to establish compensation that reasonably reflects the value of the work you actually perform.

Is There an IRS 50/50 or 60/40 Salary Rule?

You may have heard advice such as: “Pay yourself 60% in salary and take 40% as distributions.” Or perhaps you’ve heard that half of your business income should automatically become salary. Those percentages might occasionally be used as rough planning guidelines, but there is no universal IRS 50/50 or 60/40 rule for S corporation owners.

Your situation needs to be evaluated individually. For example, imagine two S corporations each generate $200,000 in income. The first is a consulting company where nearly all the revenue comes directly from the owner’s expertise and labor.

The second owns valuable equipment and has several employees who perform most of the revenue-producing work. Even though the businesses generate similar income, the owners may have very different reasonable salary amounts. That’s why relying solely on a percentage of revenue or profit can be misleading.

How Do You Determine a Reasonable Salary?

There is not one calculation that automatically determines the correct number. Instead, several factors should be considered when establishing S Corp reasonable compensation.

1. Your Job

Start with your job; what you actually do for your business. Are you primarily a manager? Salesperson? Consultant? Technician? Accountant? Designer? Doctor? Contractor? Many small business owners perform several jobs at once. You might spend part of the week generating revenue and another part managing employees, handling administration, or meeting with clients.

The more valuable services you personally provide to the company, the more important those duties become when determining your salary.

2. Total Work Hours

How much time do you work? There can be a substantial difference between an owner working five hours per week and one working 50. Consider the actual time and effort you devote to the company rather than simply choosing a salary based on what you would like to withdraw from the business. Keeping records of your responsibilities and approximate time spent performing them can also help support how you arrived at your compensation.

3. Market Rate for Your Role

What would someone else earn to do your job? This is one of the most useful questions you can ask. Imagine you stopped working for the company tomorrow and needed to hire someone qualified to replace you. What would you reasonably have to pay that person?

Research compensation for comparable positions within your industry, geographic area, and company size. Your experience, professional credentials, responsibilities, and specialized knowledge should also be considered. A highly experienced professional responsible for nearly every aspect of a profitable company probably shouldn’t be earning the same salary as an entry-level employee performing only one part of that job.

4. What Drives Revenue?

Knowing where your company’s revenue comes from is an especially important consideration. How much of your company’s revenue is generated by your personal services, and how much is produced by employees, equipment, capital, intellectual property, or other business assets?

Suppose you’re a consultant and clients are essentially paying for your personal expertise. Your work is directly responsible for much of the company’s revenue. Now consider an owner who manages a company with 20 employees who perform most of the billable work. The owner’s contribution to revenue looks very different. The source of the company’s income can therefore have a significant effect on what constitutes reasonable compensation.

5. How’s Business?

Your company’s financial condition matters, too. Revenue, profitability, company size, and other financial circumstances can help provide context when evaluating compensation. A salary that makes sense for a mature company generating substantial profits might not make sense for a new business struggling through its first year. That doesn’t mean an owner can automatically avoid payroll simply because cash flow is tight. It means the entire financial picture should be considered when determining an appropriate amount.

What Happens If Your Salary Is Too Low?

This is where aggressive tax planning can become expensive. Suppose an S corporation owner takes $15,000 in wages while receiving $150,000 in distributions. Meanwhile, that owner works full-time, manages the company, performs most client services, and generates most of the revenue.

That disparity could raise questions. The IRS has the authority to reclassify payments made to shareholder-employees as wages when appropriate. That could mean additional Social Security and Medicare taxes, along with other potential tax consequences. A better approach is to establish a defensible salary from the beginning rather than trying to explain an arbitrary number later.

Can You Pay Yourself Too Much?

Yes, and this side of the equation sometimes gets overlooked. Paying yourself substantially more salary than necessary may reduce one of the potential tax benefits associated with an S corporation. The objective isn’t to maximize your salary or minimize it.

It’s to arrive at a reasonable amount based on the facts. This is also why choosing the right business structure and electing S corporation taxation doesn’t automatically mean you’ll save money.. Payroll expenses, tax preparation costs, administrative requirements, state taxes, and your required compensation all need to be considered when determining whether the structure makes financial sense.

Get Help Determining the Right S Corp Salary

There is no magic salary percentage that fits every S corporation. Your compensation should reflect what you do, how much time you spend doing it, what comparable professionals earn, how your company generates revenue, and the overall circumstances of your business. For business owners in Temecula and throughout Southern California, The Ray Group can help evaluate compensation as part of a broader tax and accounting strategy.

With more than 25 years of experience serving businesses and individuals, The Ray Group provides tax preparation and planning, accounting, business consulting, financial reporting, QuickBooks assistance, and other services designed to help business owners make informed financial decisions.

If you’re unsure whether you’re paying yourself too much, too little, or haven’t reviewed your salary recently, talk with The Ray Group about your S Corp reasonable compensation and overall tax strategy. A little planning today can help you avoid unpleasant surprises when it’s time to file your taxes.

You may also enjoy reading: CPA small businesses Temecula