Earning Money Concept US Tax Made eZ:

Understanding S Corp Reasonable Compensation

Key Points

  • S Corp owners can take money out of the company in two ways: salary and distribution.
  • A salary is an amount paid to you on a predefined schedule like any other employee, while a distribution is a return of capital.
  • S Corp salaries need to follow reasonable compensation guidelines, which means that the amount is comparable to the going rate of the job duties performed.

Table of Contents

  1. S Corp Distributions vs Salary
  2. What is a Reasonable Salary for an S Corp Owner?
  3. Deciding How to Pay Yourself from Your S Corp
  4. How to Make an S Corp Salary Payment
  5. Reporting Your S Corp Salary on Taxes
  6. Reporting S Corp Distributions
  7. Case Studies
  8. Conclusion

Business owners often make the switch from a sole proprietorship to an S corporation to take advantage of numerous tax benefits, like lower self-employment taxes. However, S corporations are subject to more scrutiny when it comes to paying owners, meaning you need to be careful about how you pay yourself from your s corp.

An S corporation needs to abide by reasonable compensation regulations, which basically refer to being paid at the going rate for the duties you perform. If your business generates additional profits, you have other ways of removing the money.

In this article, we’ll expand on the concept of S Corp’s reasonable compensation, including when distributions come into play, how to determine a reasonable salary, and how salary and distributions get reported for tax purposes.

1. S Corp Distributions vs Salary

S corporations are pass-through entities, meaning all profit or loss eventually gets reported on your individual return through Schedule K-1. As a result, you are paying taxes at the individual level instead of the corporate level.

There are two primary ways to remove money from your S Corp: salaries and distributions. A salary is a payment like any other employee on payroll, with both employee and employer taxes required. On the contrary, distribution is a return of capital, which is tax-free if you have sufficient basis in the company.

Some of the advantages of a salary include the ability to contribute to employee benefits, like a retirement plan or health insurance. In addition, you know what to expect each pay period, giving you more stability than relying on business profits. The primary disadvantage is that both you and your company will need to pay payroll taxes.

Distributions also have their share of advantages and disadvantages. Distributions are tax-free until your basis is used up, at which point they will become taxable dividend income. Most S Corp owners that are consistently earning a profit don’t have any issues with distributions and basis. Additionally, distributions can be taken at any point and for any amount, giving you more flexibility.

2. What is a Reasonable Salary for an S Corp Owner?

If you decide to add an S Corp salary for yourself, you need to follow reasonable salary regulations. The IRS defines reasonable compensation as the amount that a similar business would pay for the same services. Your roles and responsibilities will dictate what’s reasonable for your salary. Here are some factors to consider:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to other employees
  • Timing and manner of bonus payments
  • Fair market value of services
  • Compensation agreement
  • The use of a formula to determine compensation

What the IRS decides is reasonable can be vague; however, use your best judgment. You probably shouldn’t be paying yourself a $150,000 salary if you only work 5 hours a week. Keep in mind that there is no minimum salary requirement. If your business isn’t making a profit yet, you might not be able to pay yourself the going rate.

It’s not uncommon for small business owners to wear multiple hats in the company. Let’s say that 75% of your time is spent working on research and development, and the other 25% focuses on administrative work. Engineer wages tend to be paid much differently compared to office wages.

As a result, you will need to adjust your salary to match each job description.

3. Deciding How to Pay Yourself from Your S Corp

Some business owners take a combination of salaries and distributions. The S Corp hypothetical 60/40 approach outlines that 60% of the pay from your company should be taken as a salary, and the remaining 40% should be pulled out as a distribution. Such an approach has not been approved or recommended by the IRS.

The Form 1120S instructions included a very vague explanation of calculating wages and the payment of such in relation to distribution.

Some may decide not to pay themselves for their work in the business. This idea is not recommended, as it could raise a major IRS red flag and increase one’s chances of receiving an audit.

4. How to Make an S Corp Salary Payment

After you determine the salary, the rest of paying an S Corp salary is relatively straightforward, especially if you already have a payroll for other employees. Like any other employee, you should fill out Form W-4 and all of the necessary benefit enrollment forms.

If you are processing payroll in-house, enter all of the applicable information into your payroll software. If you outsource your payroll, send all relevant information to your payroll processor. You will be added to the pay schedule like any other employee. You should not create a separate pay schedule, as this can complicate your payroll function and potentially raise more red flags. A few other things to keep in mind include:

  • Your company will pay half of your payroll taxes, which include Social Security at 6.2% and Medicare at 1.45%. You will be responsible for the other half.
  • Your company will remit unemployment taxes on your behalf, which includes both federal and state payments.
  • You will receive Form W-2 at the end of the year, which will be reported on your individual income tax return.
  • Your company will also pay workers’ comp insurance on your behalf, protecting you in the event of a workplace injury.

Even though your company will have more expenses, they are qualifying business deductions, helping you reduce your taxable income. Moreover, you have access to expanded benefits when joining payroll, which can benefit your personal financial situation now and in the future, like retirement.

5. Reporting Your S Corp Salary on Taxes

You are an employee when you receive a salary, meaning you will need to report the income on your individual income tax return. If you’ve selected your withholdings properly, you won’t have to pay any additional taxes on your salary, but you might owe taxes on your S corp pass-through income.

Your payroll provider or your in-house specialist will provide you with your W-2 by January 31st of each year. This form will not include any distributions from your company, as that is found on your Schedule K-1.

6. Reporting S Corp Distributions

The tax implications of distributions depend on your basis. Your basis in the S corp includes everything you’ve contributed and earned minus what you’ve withdrawn. Other factors can impact basis, but these are the main ones. Let’s say that you put $50,000 into your s corp and earned $75,000. Your basis before distributions would be $125,000. If you were to take a distribution of anything less than $125,000, the money would be tax-free.

However, if you were to take a $130,000 distribution, the $5,000 over your $125,000 basis would be reported as taxable dividend income on your individual return. The IRS is cracking down on distributions in excess of basis by requiring a basis schedule to be filed with your S Corp tax return each year. This makes it important to consider your basis before pulling money out of the company.

Your basis also impacts capital gains taxes when you go to sell your business. The tax base of capital gains tax is the total selling price minus your basis. If you are consistently using up your basis each year with distributions, expect to pay more taxes when you sell the business.


7. Case Studies

Case 1:

Facts:
  • Chris is the owner of a plumbing company, Jolly Plumber
  • Chris has a few employees
  • He runs the Jolly Plumber’s daily operations, but he also takes several calls a week.
  • His reasonable compensation was determined to be $100,000
  • Jolly Plumber’s net income is $500,000 after deducting reasonable compensation
  • Chris is married, and his wife Marina also earns income
  • Chris decided to take $100,000 from Jolly Plumber for this year
Issue:

How does Chris need to report his wages and distributions to avoid the IRS audit?

Calculation:
  • Reasonable compensation is $100,000
  • Desirable cash outflow is $100,000
  • Distribution is $0 [$100,000 – $100,000]
Results:
  • The entire compensation is reported as wages W-2 and Form 1120S page 1
  • Distributions are not reported and not recommended

Case 2:

Facts:
  • Chris is the owner of a plumbing company, Jolly Plumber
  • Chris has a few employees
  • He runs the Jolly Plumber’s daily operations, but he also takes several calls a week.
  • His reasonable compensation was determined to be $100,000
  • Jolly Plumber’s net income is $500,000 after deducting reasonable compensation
  • Chris is married, and his wife Marina also earns income
  • Chris decided to take $100,000 from Jolly Plumber for this year
  • NEW Chris decided to take $400,000 from the business for this year
Issue:

How does Chris need to report his wages and distributions to avoid the IRS audit?

Calculation:
  • Reasonable compensation is $100,000
  • Desirable cash outflow is $400,000
  • Distribution is $300,000 [$400,000 – $100,000]
Results:
  • The compensation of $100,000 is reported on W-2 and 1120S page 1
  • Distribution of $300,000 is reported on Form 1120S page 3, Schedule K, Form 1120S page 5, Schedule M2 and Form 7203, S Corporation shareholder stock and debt basis limitations
  • Chris does not recognize gain on the distribution

Case 3:

Facts:
  • Chris is the owner of a plumbing company, Jolly Plumber
  • Chris has a few employees
  • He runs the Jolly Plumber’s daily operations, but he also takes several calls a week.
  • His reasonable compensation was determined to be $100,000
  • Jolly Plumber’s net income is $500,000 after deducting reasonable compensation
  • Chris is married, and his wife Marina also earns income
  • Chris decided to take $100,000 from Jolly Plumber for this year
  • NEW Chris decided to take $700,000 from the business for this year
  • NEW Chris does not have a debt basis, but his beginning stock basis and capital account in Jolly Plumber is $300,000
Issues:

How does Chris need to report his wages, distributions, and potential gain to avoid the IRS audit?

Calculation:
  • Reasonable compensation is $100,000
  • Desirable cash outflow is $700,000
  • Distribution is $600,000 [$700,000 – $100,000]
  • Capital account is $200,000 [$300,000 + $500,000 – $600,000]
  • Basis is $200,000 [$300,000 + $500,000 – $600,000]
Results:
  • The compensation of $100,000 is reported on W-2 and 1120S page 1
  • Distribution of $500,000 is reported on Form 1120S page 3, Schedule K, Form 1120S page 5, Schedule M2 and Form 7203, S Corporation shareholder stock and debt basis limitations
  • Chris does not recognize gain on distribution because he had a sufficient basis

Case 4.

Facts:
  • Chris is the owner of a plumbing company, Jolly Plumber
  • Chris has a few employees
  • He runs the Jolly Plumber’s daily operations, but he also takes several calls a week.
  • His reasonable compensation was determined to be $100,000
  • Jolly Plumber’s net income is $500,000 after deducting reasonable compensation
  • Chris is married, and his wife Marina also earns income
  • Chris decided to take $700,000 from Jolly Plumber for this year
  • Chris does not have a debt basis, but his beginning stock basis and capital account in Jolly Plumber is $300,000
  • NEW Chris’s beginning stock basis and capital account in Jolly Plumber is $0
Issue:

How does Chris need to report his wages, distributions, and potential gain to avoid the IRS audit?

Calculation:
  • Reasonable compensation is $100,000
  • Desirable cash outflow is $700,000
  • Distribution is $600,000 [$700,000 – $100,000]
  • Capital account is -$100,000 [$0 + $500,000 – $600,000]
  • Stock basis is $0 [$0 + $500,000 – $500,000]
  • Gain in excess of basis is $100,000
Results:
  • The compensation of $100,000 is reported on W-2 and 1120S page 1
  • Distribution of $600,000 is reported on Form 1120S, page 3, Schedule K
  • Distribution of $500,000 is reported on Form 1120S page 5, Schedule M2
  • A gain of $100,00 is reported on Form 7203, S Corporation shareholder stock and debt basis limitations
  • Chris recognizes gain on distribution because he did not have sufficient basis to take out $600,000

Case 5:

Facts:
  • Chris is the owner of a plumbing company, Jolly Plumber
  • Chris has a few employees
  • He runs the Jolly Plumber’s daily operations, but he also takes several calls a week.
  • His reasonable compensation was determined to be $100,000
  • Jolly Plumber’s net income is $500,000 after deducting reasonable compensation
  • Chris is married, and his wife Marina also earns income
  • Chris decided to take $100,000 from Jolly Plumber for this year
  • NEW Chris decides to pass on taking any money from Jolly Plumber and grow the business
  • NEW Due to additional depreciation, Jolly Plumber projects a loss of $100,000 without even paying Chris.
  • NEW Luckily, Marina’s compensation is significant to cover the household expenses.
Issue:

How does Chris need to report his wages and distributions to avoid the IRS audit?

Calculation:
  • Reasonable compensation is $100,000
  • Desirable cash outflow is $0
  • Distribution is $0
Results:

The compensation of $100,000 can be paused for this year since no distribution is taken.


8. Conclusion

Are you currently taking a salary from your S Corp? If so, are you confident that the IRS would classify it as reasonable? Reasonable compensation is one of the top factors that the IRS will evaluate if you are the subject of an audit. It’s important to properly document how you calculated your compensation. Remember, your compensation can be adjusted as you take on new responsibilities and your business grows, but be sure that you always have a way to substantiate the amount.


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