Reasonable salary and S corp distributions

In short

A friend of mine once ran a small design studio out of a spare bedroom, and he asked me why his accountant kept fussing about what he paid himself. If you own an S corporation, you have probably wondered the same thing. The Internal Revenue Service expects an owner who works in the business to take a reasonable salary before taking any distributions. Payroll tax applies to that salary, but not to the distributions that follow. That gap is why the agency watches this closely. A salary the owner can explain, backed by records, is the kind that holds up when someone asks questions. Write down what the work is worth, keep the proof, and run payroll on schedule. Simple, but not easy.

The whole of it

What it is

I once watched a neighbor of mine split a pie three ways and then argue about who deserved the biggest slice. An S corporation owner does something like that every year, only the pie is profit and the referee is the tax code.

Here is the plain picture. An S corporation is a company that passes its profit through to its owners, who report that profit on their own tax returns. The company itself does not pay federal income tax in the usual way. An owner who also works in the business wears two hats. One hat is the employee, who earns pay for the work. The other hat is the shareholder, who receives a share of the profit.

The pay is called salary or wages. The profit share is called a distribution. Salary carries payroll taxes, which fund Social Security and Medicare. Distributions generally do not carry those taxes. So an owner has a pull toward a tiny salary and a huge distribution.

The IRS knows about that pull. Its guidance on S corporation compensation says an officer who performs services for the company is an employee. It also says the company must pay reasonable compensation for those services before distributions are made. That phrase, reasonable compensation, is the heart of the matter. It is not a number the law prints anywhere. It is a judgment about what the work is worth.

How it works

A friend of mine who farms told me once that you cannot pay the hired hand in promises and call it wages. The same thought applies here. If the owner does real work, the company must pay for that work in real wages.

The company runs payroll for the owner as it would for anyone else. It withholds income tax and the employee share of Social Security and Medicare. It pays the employer share too. It files the quarterly payroll return, Form 941, and gives the owner a Form W-2 at year end. The rules require these steps whether the owner is one person or twenty.

Distributions come after that. They are paid out of profit, and they should follow the ownership percentages. If two people own the company and one owns 60 percent, a distribution has to be split 60 and 40. Paying one owner more than their share can cause a different problem, because an S corporation may have only one class of stock.

Now, who decides what is reasonable? In a dispute, the IRS and sometimes a court look at the facts. They ask about the owner's training and experience, the duties, the time spent, what similar businesses pay for similar work, and what the company earns. No single factor settles it. The examiner looks at the whole picture, and so should the owner.

One more point deserves a quiet word. A low salary also trims the owner's retirement plan contributions and some benefits that are tied to wages. So skimping on salary can cost real money in other places. It rarely pays off the way people hope.

The numbers, and where to find yours

I like to tell folks that a number you cannot find is a number you cannot trust. So here is where each one lives.

The Social Security wage base is the amount of wages above which Social Security tax stops applying. It changes every year. For this year it is the current figure, which the official source publishes each year. The Social Security Administration publishes it on its contribution and benefit base page. The Social Security tax rate is the current figure, which the official source publishes each year for the employee and the same for the employer. The Medicare rate is the current figure, which the official source publishes each year for each side. The IRS explains these in Publication 15, known as the Employer's Tax Guide.

The salary itself has no official table. No chart from the IRS says what a given owner should be paid. The IRS looks at what outside pay data shows for the same kind of work in the same area. The Bureau of Labor Statistics publishes occupational wage data through its Occupational Employment and Wage Statistics program. Recruiter salary surveys and job postings can add support. Keep copies of whatever the owner uses.

The owner's own numbers are in the company books. Find the company's net profit, the hours the owner works, and the duties the owner performs. Those three facts do much of the talking if anyone ever asks.

A worked example

Let me tell you about a woman named Marisol, who runs a small engineering consulting company as the only owner and only worker. Last year the company took in $180,000 in revenue. After $40,000 of expenses, before paying herself, the profit came to $140,000.

Marisol first thought she could pay herself $20,000 and take the rest as distributions. A friend nudged her to look at the pay data. For the sake of the story, suppose the pay data she found showed engineers doing similar work at a firm earning about $95,000 a year. She was doing the same work, plus running the business.

She settled on a salary of $85,000, a bit under the market figure because she handled fewer administrative tasks than a full time employee would. She wrote a short memo explaining how she got there and saved the pay data with it.

Her payroll tax works out like this. Using the 7.65 percent combined Social Security and Medicare rate for each side, $85,000 times 7.65 percent is $6,502.50 from the employee side. The employer side is the same $6,502.50. Together that is $13,005.

The distribution is what remains of the profit after the salary and the employer's payroll tax. Start with $140,000. Subtract the $85,000 salary, which leaves $55,000. Subtract the $6,502.50 employer tax, which leaves $48,497.50 available to distribute.

Compare her first idea. A $20,000 salary at 7.65 percent per side is $1,530 each, or $3,060 together. That looks like savings of $9,945, because $13,005 minus $3,060 is $9,945. But a $20,000 salary for a working engineer is far below what the market pays, and that is exactly what an examiner would circle in red. If the IRS reclassified part of the distributions as wages, Marisol could owe the unpaid payroll tax, interest, and penalties. The savings would be gone, and then some.

Marisol slept fine. That counts for something.

Where it goes wrong

I have seen good people stumble here, and almost never out of bad intent. Mostly they were busy and hopeful.

The first slip is paying no salary at all. An owner who works in the business and takes only distributions is the clearest case the IRS looks for. Courts have sided with the government in cases like that, treating the distributions as wages.

The second slip is a salary that is plainly too low for the work. A $12,000 salary for someone running a $2 million company draws attention. The size of the gap matters.

The third slip is thin records. If an examiner asks how a salary was chosen, a shrug does not help. A short memo and a few pay comparisons do.

The fourth slip is sloppy payroll. Late deposits, missing quarterly returns, and no W-2 turn a quiet question into a loud one. The company must deposit withheld taxes on the required schedule.

The fifth slip is mixing in personal spending. Paying a personal bill from the company account and calling it a distribution muddies the books. Keep the two apart.

Careful owners avoid all five. None of it takes genius. It takes a little attention, once a year, and a steady habit.

Questions to answer before you leave this page

What work do you actually do for the company each week, and how many hours does it take? When a company hires someone else to do that same work, the pay in that area is the natural yardstick for a fair salary. Have you saved the pay data or survey that supports your number, and does a short memo explain how you got there? Is payroll running on a regular schedule, with deposits made on time and quarterly returns filed? Do your distributions follow the ownership percentages exactly? Have you checked the current Social Security wage base and rates on the official pages before you set this year's salary? And if an examiner called tomorrow, could you hand over a folder that tells the story calmly and clearly?