At least a few times per year, I am asked the question, “How much should I be taking as a salary?” This question is particularly important for my S corporation clients because paying too much or too little salary has important tax consequences. An S corporation is required to pay its shareholder reasonable compensation for the services performed for the S corporation. If the S corporation is not paying a reasonable salary to its shareholders, the IRS may re-characterize distributions or reassign income to properly reflect the value of the services provided.
Accordingly, below are a few considerations that should be evaluated when determining compensation payments:
- Currently, S corporation shareholders have the unique advantage of not having their S corporation income subject to self-employment tax of 15.3 percent. This is different than the earnings attributable to a sole proprietor, a general partner, or many LLC members that would have their trade or business income subject to self-employment taxes. As such, there is incentive for S corporation shareholders to minimize their salaries.
- Are the S corporation shareholders receiving unreasonable distributions? S corporation distributions are non-taxable up to a shareholder’s tax basis and therefore a distribution payment is preferred over taxable wages. Distributions made by the S corporation that provide a very high rate of return to the shareholder may result in the IRS questioning whether the shareholder’s salary is too low.
- With the recent passage of Section 199A, pass-through entities such as S corporations are afforded an additional 20 percent tax deduction against their qualified business income. Thus, if you reduce the shareholder’s salary, this will directly increase the S corporation’s qualified business income and related 20 percent tax deduction. However, one of the conditions needed to qualify for the 199A deduction is that the company must have wages. Therefore, an analysis should be performed in order to find the proper balance between the amount of wages paid versus qualified business income needed to maximize this deduction.
- Does the corporation have family members as shareholders? If so, do their salaries correspond with the services being provided to the corporation or is income being shifted to lower bracket family members?
- Is the shareholder compensation too high, resulting in the S corporation operating at a loss? This loss may be nondeductible if it exceeds the shareholder’s tax basis, but all of the salary is taxable.
This issue of reasonable compensation has been a long-standing dispute between the IRS and taxpayers. There are no specific guidelines for determining reasonable compensation in the Code or the Regulations. Instead, the various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case. No one factor is decisive, and each situation has its own unique facts and circumstances.
Some factors considered by the courts in determining 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
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
When reviewing these factors, keep in mind that a shareholder with significant experience and responsibilities would warrant a higher salary in comparison to a retired shareholder that spends minimal time in the business. Similarly, when reviewing the company’s dividend history, consider the rate of return and the ratio of shareholder compensation compared to distributions. The IRS may be less motivated to question the company’s distributions if the shareholder’s compensation exceeds the Social Security wage base for the year. Finally, the company should review various salary benchmarking resources to ascertain what salaries are being paid to individuals in similar fields.
As in most tax situations, planning ahead avoids problems later. Once the compensation amount is determined, it should be documented as to reasons for the amount of compensation paid. This can be done in the corporation’s board of directors minutes or via a compensation plan with the shareholder.
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