Advising S Corporation Clients on Reasonable Compensation

Reasonable compensation is one of the most misunderstood and debated topics for S-Corporation (S-Corp) owners. Whether you’re newly electing S corp status or optimizing an existing structure, our expertise ensures your salary maximizes tax savings while withstanding IRS scrutiny. If expenses exceed revenue, there’s no profit to distribute and no income from which to pay salary. You cannot pay yourself $85,000 (the business doesn’t have sufficient income).

Key takeaways

On its website, the IRS cites the Watson case and several others as “supporting the authority of the IRS to reclassify other forms of payment to a shareholder-employee as a wage expense that is subject to employment taxes.” You can easily find the story online of David Watson, a CPA who took a $24,000 annual salary from his S Corporation while receiving $220,000 in distributions, on which he didn’t pay employment taxes. This became a problem in the early 2000s when the IRS determined that hundreds of thousands of single-shareholder S Corporations were paying no salaries to owners and collecting distributions instead. According to IRS rules, an S Corporation must pay reasonable compensation to each shareholder. Shareholders who work for their C Corporation are company employees and have taxes withheld from their pay. A C Corporation is taxed as its own independent tax entity, filing its own income tax returns and paying taxes at the applicable corporate tax rates.

Advanced S-Corp Salary Strategies

Determining a reasonable salary can be a complex process, and factors such as training, experience, duties, responsibilities, and payments to non-shareholder employees should be considered. By thoroughly assessing these factors and maintaining accurate payroll records, S Corps can confidently determine a reasonable salary that is fair, competitive, and compliant with tax obligations. To establish a reasonable salary for S Corp shareholder-employees, it is essential to compare the wage models of comparable businesses within the same industry. This ensures that the corporation’s income is reported on individual tax returns and avoids imposing taxes at both the corporate and individual shareholder levels. In contrast, a C Corporation is subject to double taxation, as it pays taxes at the corporate level, and its shareholders also pay taxes on any dividends received. Easily run different scenarios between wages and profit sharing and see their impact on payroll taxes.

Accounting Services

If your business is an S corporation (or S corp), here’s what you need to know to keep the IRS—and your shareholders—happy. The IRS defines reasonable compensation as what a similar business would pay someone else to perform the same job under similar conditions. Whether you’re trying reasonable salaries and s corps to reduce corporate taxes or payroll taxes, the IRS is watching.

Private practice owners typically exceed employed PT salaries due to business management duties. The IRS can’t require salary payments the business can’t afford. Illinois unemployment insurance rates vary significantly based on experience rating, affecting the total cost of reasonable compensation compliance. The Metropolitan Commuter Transportation Mobility Tax affects businesses in NYC and surrounding counties, adding 0.34% on payroll expenses.

There’s no formula that the IRS uses/a published calculation taxpayers can use to determine their salary. But as you’ll see throughout this article, it gets much more complex than that and there are multiple ways you can approach a reasonable salary calculation. Too low and you run the risk of IRS scrutiny, distributions being reclassified as wages, and paying significant penalties.

How does one calculate a reasonable salary in an S Corp?

Miami’s international business environment pushes professional salaries higher, typically $80,000-$145,000. A software engineer-owner managing a development firm should expect to justify salaries between $120,000-$200,000. Despite its popularity among some tax preparers, this rule has no IRS endorsement, no legal standing, and no safe harbor protection. The court found this laughably inadequate for someone with his qualifications and reclassified $151,000 as wages. Let’s examine what actually happens when the IRS challenges your salary determination. While this creates a legitimate tax-planning opportunity, the IRS watches closely for abuse.

Higher salaries reduce audit risk but also reduce tax savings.
Keeping track of compensation shortfalls is essential for future compliance.
Using artificial intelligence and advanced technology, the IRS aims to enhance its detection capabilities for tax-compliance issues and emerging threats, thereby improving case selection.
As did Mr. Goldsmith, Mr. Singer raised money for his business from the equity in his home.

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The first problem here is that the agent did not take into account any loans Mr. Goldsmith made to G&A. Beyond being costly, unnecessarily high wages are not even what the IRS requires. But that year the business had an $80k loss. There are risks you run by overpaying yourself. You don’t want any IRS scrutiny or to pay penalties, after all. Despite this, he only paid himself a $24,000 salary.

Filing the Election with IRS Form 2553

Check to see what other companies of similar size and type pay for such services. Along with teaching at business and professional schools for over 35 years, she has author several business books and owned her own startup-focused company. These are the best states to incorporate your business in. Dive into rental income tax, property deductions, and landlord write-offs.

Date the study and update it annually as market conditions and your role evolve.
The IRS can reclassify payments to shareholders from distributions that weren’t correctly classified and call them wages.
Certain fringe benefits are included in an S corp owner’s taxable income but are NOT subject to Social Security or Medicare taxes.
So any income you take as distributions rather than salary saves you that cost in taxes.

S corporation shareholders as employees

Internal Revenue Code makes it mandatory for shareholder of S Corp to Pay a Reasonable Salary. Self employment tax is 15.3% for up to $142, 800 (for 2021) of self employment earnings. Many Small Business Owners setup S Corp to help lower self employment tax.

After successfully electing S corp status, the company is required to file an annual income tax return using Form 1120S, titled “U.S. To become an S corporation, a company must first file a completed Form 2553 with the Internal Revenue Service (IRS). Gathering recommendations from colleagues or researching online reviews can help identify a reliable tax professional for assistance in evaluating and establishing a defensible salary benchmark for S Corp owners. Penalties can include back taxes, interest, and fines for the underpayment of payroll taxes, along with the risk of an audit. Employee wages should be competitive and in line with the services provided to the corporation.

Free downloadable bookkeeping and tax guides, checklists, and expert-tested accounting templates Get free guides, articles, tools and calculators to help you navigate the financial side of your business with ease. Book a demo today to see what running your business is like with Bench. Access or download your updated income statement or balance sheet at all times

Business changes, market shifts, and role evolution all matter. A business accountant in rural Texas earns less than their Dallas counterpart. Robert Half and similar firms publish annual salary guides. For example, “Chief Executives” in Dallas-Fort Worth average $213,000, but adjust this based on company size.

Myth 2: You Don’t Need a Salary if You Don’t Take Distributions

For 2025, job market trends and rising prices have boosted pay levels in many fields, meaning S-Corp owners should take another look at their compensation setups. Take too little salary, and you risk the IRS recategorizing those distributions as wages during an audit, sticking you with back taxes, penalties, and interest. Both salary and distributions count as income on your personal tax return, but only salary gets hit with employment taxes (that 15.3% for Social Security and Medicare). The IRS says reasonable compensation is what you’d typically pay someone for similar work in a similar business under similar conditions. Electing S Corp status can be advantageous when the potential tax savings from pass-through taxation and lower rates on non-wage distributions outweigh the payroll taxes and additional compliance requirements.

How does the IRS determine if my S-Corp salary is reasonable?

Payroll taxes, such as FICA (Social Security and Medicare taxes), must be withheld and reported on a timely basis to avoid penalties. Failure to comply with these regulations may result in penalties, additional taxes, and potentially losing the S Corp status. S Corporations and C Corporations are two types of corporations that exist in the United States. Easy-to-use sliders allow you to test different scenarios between W-2 salary and profit sharing in real time.