How to set a reasonable salary as an S-corp owner

If you own an S corporation and work in it, the IRS expects you to pay yourself a salary before you take distributions. The hard part is the amount. No published table gives you a number. You have to decide on a salary you can explain and back with records.

This guide covers what the IRS says about reasonable compensation, the factors it looks at, and a step-by-step way to set your own salary and write down why you chose it.

Why the IRS cares about your salary

Wages and distributions are taxed differently. Wages are subject to employment taxes. Non-wage distributions are not. That gives owners a reason to keep wages low and distributions high.

The IRS says S corporations must pay reasonable compensation to a shareholder-employee for the services that person provides before making non-wage distributions to them. The IRS can also reclassify distributions as wages, which makes them subject to employment taxes.

The Form 1120-S instructions put it this way: "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."

Are you an employee of your own S corp?

Usually, yes. For FICA, FUTA and federal income tax withholding, the definition of employee includes corporate officers. When officers perform services and receive payments, or are entitled to them, those payments are wages. Being a shareholder too doesn't change that.

There is one narrow exception. An officer who performs no services, or only minor services, and is not entitled to compensation is not considered an employee. If you run the business day to day, this exception almost certainly doesn't apply to you.

What courts have said

The IRS points to several court cases that support its position:

• Veterinary Surgical Consultants, P.C. (2001): The Tax Court ruled that a corporation can't avoid federal taxes by calling its sole shareholder's pay distributions of net income instead of wages.
• Joseph M. Grey Public Accountant, P.C. (2002): An accountant took dividends while performing duties for the company. The court ruled the dividends were wages.
• Joly v. Commissioner: A shareholder used the company bank account for personal use and was found to be an employee who owed employment tax.
• David E. Watson, PC (8th Cir. 2012): The shareholder was paid $24,000 a year in wages along with large distributions. The company argued it only intended to pay $24,000. The court said intent doesn't control. The test is whether the payments were really pay for services performed.

The Watson case matters because the owner did pay a salary. The salary was just too low for the work being done. Paying some salary does not settle the question. It has to be a reasonable salary.

Where your company's income comes from

The IRS says the key to reasonable compensation is figuring out what the shareholder-employee did for the business, by looking at the source of the company's gross receipts. It names three main sources:

1. Services of the shareholder
2. Services of non-shareholder employees
3. Capital and equipment

Receipts from your employees' work or from capital and equipment can properly flow to you as distributions. Receipts from your own personal services should be paid to you as wages.

Administrative work counts too. If you manage the people or equipment that bring in revenue, the IRS says that work should also be treated as wages, even if you don't produce receipts directly.

A one-person service business, where nearly all the revenue comes from the owner's own work, will generally need to treat more of the owner's pay as wages than a business where employees or equipment produce most of the revenue.

Factors the IRS lists

The IRS gives these factors for determining reasonable compensation:

The IRS doesn't say how much weight each factor gets. Use all of them, and write down how you applied each one.

Step-by-step: setting your salary

1. List your roles. Write down everything you do: the main service you sell, sales, management, bookkeeping, hiring. Many small-business owners do several jobs.
2. Estimate your time. Note roughly how many hours a week go to each role.
3. Find comparable pay. For each role, look up what a business like yours would pay someone else to do that work. Save copies of whatever you used.
4. Look at revenue sources. Estimate how much of your gross receipts comes from your own work, from employees, and from capital and equipment. The bigger your own share, the more of your pay should be wages.
5. Check your other employees. Your salary should make sense next to what you pay others for related work.
6. Pick a number and write it down. Record the salary in a board resolution or compensation agreement, with a short note on how you got there.
7. Run it through payroll. Pay the salary through regular payroll with withholding and employment taxes. See How to run S-corp owner payroll yourself for the mechanics.
8. Review it every year. Duties, hours and revenue change. Update the salary and your notes when they do.

For how salary and distributions work together in practice, see How to pay yourself from an S corporation.

Watch for disguised wages

Courts have treated several kinds of payments as wages even when they weren't called wages:

• Personal expenses paid by the company. In Ghosn, the corporation's payment of the shareholder's personal insurance and utility bills was treated as compensation for services.
• "Loans" to the owner. In Gale W. Greenlee, Inc., unsecured, interest-free demand "loans" to the sole shareholder were treated as wages for FICA and FUTA purposes.
• Payments called distributions or loan repayments. In Glass Blocks Unlimited, payments to the president and sole shareholder were ruled to be wages.

The IRS also notes that reasonable compensation will never exceed what the shareholder received, directly or indirectly. If you took nothing out of the company, there's nothing to reclassify. But if you received or had the right to receive cash or property, the corporation must determine and report a reasonable salary for you.

Health insurance and your salary

If you own more than 2 percent of the company, health and accident insurance premiums the S corporation pays for you are reported as wages on your Form W-2 and are subject to income tax withholding. When paid under a plan for all employees or a class of employees, they go in Box 1 but not in Boxes 3 and 5, so they aren't subject to Social Security, Medicare or FUTA.

These premiums are part of your W-2 reporting, but they don't replace a cash salary for your services. The rules here have more detail, including on above-the-line deductions, so check the current IRS guidance or ask a CPA. When you prepare year-end forms, see How to file W-2s and W-3 through SSA Business Services Online.

Quick checklist

• I perform more than minor services, so I treat myself as an employee.
• I've listed my duties and estimated my hours.
• I've gathered comparable pay data and saved copies.
• I've estimated how much revenue comes from my own work.
• My salary is recorded in a resolution or agreement, with my reasoning.
• I pay my salary through payroll before taking distributions.
• I don't run personal expenses or informal "loans" through the company in place of wages.
• I review my salary every year.

Underpaying wages can lead to reclassification and back employment taxes. See Payroll tax penalties and how to avoid them for what's at stake.

Where Selfroll fits

Selfroll is a free payroll calculator for small S-corp owners. Once you choose your salary, it does the withholding and payroll tax math, keeps a deadline calendar, and fills draft forms for you to review. You send the pay from your own bank, make the deposits, and file the forms yourself.

Sources

• IRS: S corporation compensation and medical insurance issues
• IRS: S corporation employees, shareholders and corporate officers

This guide is general information, not tax or legal advice. Check current IRS, SSA and state rules or ask a CPA.