Reasonable salaries: What every S corp owner needs to know

As an ecommerce owner, operating your brand as an S corporation can save you real money come tax time. But, be ready that it also comes with a set of pretty strict conditions that must be met to avoid the wrath of the IRS.

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In this post, we'll discuss what you need to know to enjoy the tax-saving benefits of S corp status while keeping the IRS off your back.

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What are the benefits of an S corporation?

Operating as an S corp may be the most tax-efficient choice since:

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1. Federal tax is only paid once (by the shareholders, not the corporation)

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Unlike a C corp, for an S corp, taxes are only paid by the shareholders. The corporation itself is not obligated to pay federal income tax. Instead, an S corp's net income is allocated to each shareholder based on their ownership percentage. You, as a shareholder, then need to pay income tax on your personal tax return for that income.

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2. There is no self-employment tax on your share of income from the S corp

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For a partnership (or an LLC that doesn't elect to be an S corp) all income allocated to the partners is subject to both income tax and self-employment tax. But, as an S corp shareholder, you are only subject to income tax on your portion of the income, not self-employment tax. As an estimate, this could save you about 14.13% in taxes!

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To give a real-world example:

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$100,000  Business Net Income

-    7,650   Tax deduction for employer portion of self-employment tax

X   15.3%  Self-employment tax rate (employer and employee)

$14,130    Self-employment tax saved, or 14.13% of your net income

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So far sounds great, right? Before you sign the S corp election form, there is some fine print you need to keep in mind. One key condition to enjoy this benefit, is that you must first pay yourself a reasonable salary.

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Let's understand this a bit more.

How do you determine reasonable compensation for an S corporation owner?

The IRS wasn't too thrilled about the fact that a shareholder can choose to receive all the income as a distribution and not pay themselves a salary for their services, resulting in less Social Security and Medicare taxes. Less taxes = sad IRS.

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To prevent this, the IRS requires all shareholders that are also employees, to pay themselves a reasonable salary before taking out any distributions from the company.

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What does this mean for you? Well, as a shareholder-employee, you must be on the payroll of your company and must pay payroll tax on the salary you receive, unless you don't plan to take any money or distributions from the business.

There is a battle of wills here that exists between shareholder-employees and Uncle Sam. As a shareholder, you want your salary to be as low as possible to increase the profits from your company while also decreasing your payroll tax liability - the exact opposite of what the IRS wants.

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The IRS balances this out by imposing a minimum rule - the salary you pay yourself must be reasonable. Gee, thanks IRS, way to be super clear and not vague at all (heavy emphasis on the sarcasm here). 

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The IRS provides a bit of guidance by saying the following factors should be considered:

• Training/education and previous experience
• Your duties and responsibilities in running the business
• Distribution history
• The time you devote to the business
• Payments to non-shareholder employees
• What similar businesses pay for similar roles

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Ask yourself 2 main questions:

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1. If you were performing the same duties at another company that you don't own, what would you expect the other company to pay you?
2. If you were to hire someone to take over all of your responsibilities for your S-corp, how much would you pay them?

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A rule of thumb that has been used by many is the 60/40 rule. Divide your business income into 2 parts and designate 60% as salary and 40% as a distribution.

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Of course, if you aren't paying any distributions, you don't need to take any salary since reasonable compensation is limited to distributions you actually took from the business.

For example, if in Year 1 you took $30k from the business and a reasonable salary is $50k, you only need to pay yourself a salary of $30k. Word to the wise - IRS looks at reasonable compensation on a cumulative basis. What this means is that in Year 2, instead of paying yourself a reasonable salary of $50k, you would need to pay yourself a salary of $70k ($50k for Year 2 + $20k that you didn't pay yourself from Year 1) before taking a distribution from the company.

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The U.S. Bureau of Labor Statistics can provide you with average compensation numbers in different fields based on experience. You can also use benchmark studies such as salary.com, indeed.com, monster.com to get a better idea of what's reasonable based on your experience and the size of your ecommerce business. 

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Contact a payroll provider, such as Gusto (if the company does not already use one) to make sure payroll taxes are taken care of.

What happens if the IRS decides your compensation isn't reasonable?

Well, I'll tell you this. It ain't pretty.

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The IRS has the authority to reclassify your distributions as wage payments subject to payroll taxes. If, during an IRS audit, a salary is determined to be unreasonable, the S corp can be fined a penalty and interest if the amount a shareholder is paid is 10% or $5,000 below market value.

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Make sure to document your findings so you can demonstrate why you believe your salary is reasonable. This way, you can pull it up in case you are questioned by the IRS.

About Finaloop

We are a technology company providing automated end-to-end accounting service to ecommerce businesses. Our system connects to your apps, syncs all your data and reconciles your books in real-time, replacing your bookkeeper. We offer reconciled books available 24/7, tax-saving insights, and a single place for all your financial data.

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^{*The information provided on this website does not, and is not intended to, constitute legal advice. All information, content, and materials available on this site are for general informational purposes only. Readers are advised to consult with their attorney or accountant with any questions or concerns.*}