A subchapter S-Corporation, also referred to as an S-Corp, is one of many types of business structure. This type of entity does not pay taxes at the corporate level. Instead, the net profits from this type of company are treated as personal income for the owner(s). The S-Corp files form 1120S then provides all its shareholders a form K1 to file on their personal tax return.
One of the greatest benefits of an S-Corp is the tax savings. Net profit from the S-Corp is not subject to self-employment taxes. What??? That’s 15.3% saved on taxes. Let me explain. Let’s put our employee hat on for a moment. When you receive your W2 from your employer, there are 3 boxes of taxes withheld, Federal Withholding, Social Security (6.2%), and Medicare taxes (1.45%). For Social Security and Medicare, your employer matches your amount and must pay both your share and their share to the IRS.
When you are self-employed you are the employer AND the employee. Therefore, you are now responsible for paying both shares of Social Security and Medicare taxes. Self-employment taxes are a combination of both Social Security (12.4%) and Medicare Taxes (2.9%) – 15.3%.
There are two main ways to take money out of your S-Corp, 1) payroll wages and 2) distributions. Taking 100% of your profits through payroll wages will result in you paying 15.3% in payroll taxes on 100% of the money. That defeats the advantage of having an S-Corp.
● Distributions: defined as any funds that you withdraw from your company or use for personal expenses without going through payroll. See a few examples below:
○ Transfers to personal account
○ Checks written to owner that are not payroll checks
○ Personal nail salon visit charge to business card
Distributions are not subject to self-employment taxes. Because of this, the IRS would not want an owner/shareholder to take 100% of their profit via distributions and never pay a penny in payroll taxes. Therefore the “reasonable compensation” requirements exist. It is ideal for shareholders to find a balance between distributions and compensation when taking profits out of their S-Corp.
● S-Corp Shareholders: also known as employees -shareholders, are defined as people who own a part of the S-Corp business.
The murky area happens because the IRS requires that S-Corps take a “reasonable compensation” through payroll before the business owners can distribute non-wage payments, but they don’t provide specific guidelines, stating:
“The amount of the compensation will never exceed the amount received by the shareholder, either directly or indirectly. However, if cash or property or the right to receive cash and property did go to the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.
There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.”
Those who aren't trained CPAs might find the specifications confusing. In this article, WATS CPA, will discuss some factors to consider in determining reasonable compensation with the goal of empowering business owners to better manages finances.
To help clarify, the general rule is that shareholders should always receive more compensation (wages on a W2) than distributions.
The Factors Involved In Determining Compensation
Check out these things to consider when deciding how much compensation each shareholder should receive via payroll versus distributions.
Training And Experience
Shareholder-employees typically make more as they attain more experience and skill sets, especially when compared to similar roles in the general market. Paying an experienced associate at an entry level wage would be a red flag.
Responsibilities and Workload
Employees with a lot of high-level responsibilities typically earn more than entry-level employees with few responsibilities. Are you paying yourself more than you are paying your admin staff?
Business Related Efforts and Time
Your daily contributions to an S-Corporation should also be considered when determining your compensation. Longer and more intensive work hours warrant higher salaries.
What Are Other Businesses Paying For Similar Services?
In order to come up with a reasonable owner-employee pay rate, you should analyze the salaries of employees in businesses like yours. If you want to use this method, look at the average salary of several similar jobs. To find out the pay in your area, you can always consult a compensation expert.
History Of Distributions
If your distributions are more than your wages, you run the risk of having the IRS reclassify your distributions as wages. With the reclassification comes back taxes, interest, and penalties.
In Conclusion
Determining what is a reasonable compensation for your S-Corporation involves a full analysis of all factors surrounding your business and the nature of your workload. If you would like to take advantage of this tax savings vehicle, but nervous about implemented a reasonable salary, contact us a WATS CPA for a 1-on-1 consultation.