Reasonable Salary For S-Corporations
Businesses that elect to be taxed as S-corporations by the IRS are required to pay owners a reasonable salary. Opinions differ as to what is reasonable and what is not, and many business owners wonder what will happen if the salaries they draw from their S-corps do not meet the IRS definitions.
What Is A Reasonable Salary?
The IRS does not provide specific guidelines for what is considered reasonable. However, various courts have ruled on the issue, and the following factors have been used to determine reasonable compensation:
- Training and Experience
- Duties and Responsibilities
- Time and Effort Devoted to the Business
- Dividend History
- Payments to Non-Shareholder Employees
- Timing and Manner of Paying Bonuses to Key People
- Comparable Salaries at Other Companies
- Compensation Agreements
It should be immediately clear that what the courts (and thus the IRS) do not consider is whether or not the company owners consider the wage reasonable. All too often, courts have seen owners attempt to dodge taxes by paying themselves meager salaries and accepting the remaining profits as dividends.
If Compensation Isn’t Reasonable
If the IRS reviews compensation of S-corporation owners and decides that the salaries being paid are not reasonable (meaning “too small”), then it will reclassify other compensations and deem them as wages. Other compensations are generally dividends, but they can also be payments for healthcare, insurance, utilities and other such expenses. Compensation that was previously considered non-wage will be allocated to wages, and the IRS will then determine what taxes are owed on the new wage amount.
Joe is the sole owner of an S-corporation. The company makes $250,000 a year, and Joe paid himself a salary of $30,000. After expenses, Joe issued himself $175,000 in dividends for the year.
After an IRS audit, it was determined that Joe’s $30,000 salary was unreasonable.
The IRS determined that a reasonable salary for Joe’s position was $100,000. Thus it reclassified $70,000 of Joe’s dividends, turning them into wages. Joe is now required to pay federal income taxes on $100,000 instead of only $30,000.
Determining A Reasonable Salary
Compare Salaries With Other Companies
The best way to determine if your salary is reasonable is to compare it with salaries given to individuals performing the same job and with the same basic qualifications. It is not necessary for your salary to be exactly the same as that of other individuals in your position. After all, salaries are weighed against a host of factors.
There should be, however, a fair degree of parity. The wider the margin of difference, the more likely it will be that the IRS will determine your salary is insufficient.
Compare Salaries Within Your Own Company
If you have ten years of experience in your field and pay the recent college graduate you just hired a larger salary than your own, the IRS is going to have some questions about your salary practices.
So compare your salary to others in your company who perform the same work and have similar levels of experience. If your salary is far below theirs, the IRS will likely consider this a problem.
Hypothetical Sale of Your Company
Imagine that you have decided to sell your company, but the new buyer wants you to stay on for a period of six months to smooth over the transition. What salary would you ask for in this scenario? Whatever number you feel is appropriate is likely to be a good indicator of a reasonable salary.