If you’re a business owner or a freelancer, you may have heard about S corporations and the reasonable salary guideline. But what does it all mean? As an S corporation owner, you have the flexibility to pay yourself a salary and receive distributions from the company’s profits.
However, the IRS requires that you pay yourself a reasonable salary that is subject to payroll taxes, while the remaining profits can be distributed as dividends that are not subject to self-employment taxes. Since the payroll taxes are in addition to income taxes, there might be a motivation to take lower salary and lower the taxes paid.
Navigating the complexities of S corp salary can be challenging. That’s why in this article, we’ll provide you with a clear understanding of the 60/40 rule, how to determine a reasonable salary, and how to ensure compliance with the IRS. So, whether you’re considering forming an S corporation or you’re already operating one, this article will demystify the S corp salary and help you make informed decisions for your business.
What Is an S-Corporation?
Before we dive into the details of S corp salaries, let’s start with the basics. An S corporation is a type of corporation that has elected to be taxed as a pass-through entity. This means that the company’s profits and losses are passed through to the shareholders (owners) of the company, who report them on their individual tax returns. One of the significant advantages of an S corporation is that it provides liability protection for the shareholders. This means that the shareholders’ personal assets are protected from the company’s liabilities.
To qualify as an S corporation, the company must meet certain requirements, including having no more than 100 shareholders, having only one class of stock, and being a domestic corporation. Additionally, all shareholders must be individuals, estates, or certain types of trusts.
Understanding the 60/40 Rule
Now that we’ve covered the basics of S corporations let’s dive into the 60/40 rule. The 60/40 rule is just a rule of thumb and not an IRS rule or guideline.
Based on this rule, an S-Corp owners pay themselves 60% of the profits as salary and the remaining profits can be distributed as dividends that are not subject to self-employment taxes.
The purpose of the 60/40 rule is to prevent S corporation owners from avoiding payroll taxes by taking all of their compensation as distributions. By requiring S corporation owners to pay themselves a reasonable salary, the IRS ensures that they are paying their fair share of payroll taxes
How to Calculate S Corp Salary
Calculating a reasonable S corp salary can be challenging. There is no one-size-fits-all approach, as the salary will depend on various factors, including the company’s industry, the owner’s role in the company, and the company’s profitability. However, there are several methods that S corporation owners can use to determine a reasonable salary.
One method is to use industry benchmarks. Many industries have established salary ranges for different roles within the company. S corporation owners can use these benchmarks as a starting point for determining a reasonable salary.
Another method is to use the “reasonable compensation” test. The reasonable compensation test considers the owner’s role in the company, their experience and qualifications, and the company’s profitability when determining a reasonable salary.
It’s important to note that S corporation owners should document their methodology for determining a reasonable salary to ensure compliance with the IRS.
Benefits of Taking a Salary from an S Corp
Taking a salary from an S corporation has several benefits. First, it provides the owner with a steady source of income. Unlike distributions, which can vary from year to year, a salary provides a consistent income stream.
Second, taking a salary can help maximize retirement contributions. S corporation owners can contribute to a retirement plan based on their salary rather than their distributions. This can help maximize their retirement savings.
Finally, taking a salary can help establish credibility with lenders. Lenders may be more willing to lend to a company that has a consistent source of income.
Example of Reasonable Compensation
Consider an example of a doctor who is employed full time with a hospital but all has a small side practice that generates about $300,000 in profits each year. This side practice is incorporated as an S-Corp and the doctor needs to have a W-2 compensation from the S-Corp. As an example, a compensation of $25,000 would not seem ‘reasonable’ as it would not be on par with compensation paid to doctors.
Tax Implications of S Corp Salary
As we mentioned earlier, S corporation owners must pay themselves a reasonable salary that is subject to payroll taxes. Payroll taxes include Social Security and Medicare taxes, which are currently set at 12.4% and 2.9%, respectively.
In addition to payroll taxes, S corporation owners must also pay income taxes on their salary. The salary is reported on the owner’s individual tax return and is subject to federal and state income taxes.
Any remaining profits that are distributed as dividends are not subject to payroll taxes. However, they are subject to income taxes. The tax rate on dividends depends on the owner’s individual tax rate.
Common Mistakes to Avoid When Calculating S Corp Salary
Calculating a reasonable S corp salary can be challenging, and there are several common mistakes that S corporation owners should avoid. One mistake is underpaying themselves to avoid payroll taxes. While it may be tempting to take all of your compensation as distributions, this can lead to penalties and interest charges from the IRS.
Another mistake is overpaying yourself. Overpaying yourself can lead to higher payroll taxes and lower profits for the company.
Finally, failing to document your methodology for determining a reasonable salary can lead to compliance issues with the IRS. S corporation owners should keep detailed records of their salary calculations to ensure compliance with the 60/40 rule.
S Corp vs. LLC’s taxed as Sole Proprietor: Which Is Right for You?
S corporations and sole proprietorships are both popular business structures for small business owners. While both provide liability protection for the owners, there are some significant differences between the two.
One of the significant differences is in taxation. S corporations are taxed as pass-through entities, while LLCs can be taxed as pass-through entities or as a corporation.
Another difference is in ownership. S corporations are limited to 100 shareholders, while LLCs can have an unlimited number of members.
Choosing between an S corporation and an LLC depends on several factors, including the company’s goals, the number of owners, and the desired taxation structure. It’s essential to speak with a financial advisor or a business attorney to determine which business structure is right for your company.
Working with a CPA to Optimize Your S Corp Salary
Calculating a reasonable S corp salary can be challenging, and working with a CPA can help ensure that you are making informed decisions for your company. A CPA can help you determine a reasonable salary based on industry benchmarks and the reasonable compensation test.
Additionally, a financial advisor can help you create a financial plan that maximizes your retirement contributions while minimizing your tax liability. They can also help you navigate compliance issues with the IRS.
Resources for Further Education on S Corp Salaries
If you’re interested in learning more about S corp salaries, there are several resources available. The IRS website provides comprehensive information on S corporations and the 60/40 rule.
Additionally, many financial advisors and business attorneys specialize in working with S corporations and can provide guidance on compliance issues and optimizing your S corp salary.
Conclusion
Understanding S corp salaries and the 60/40 rule is essential for any business owner or freelancer who operates as an S corporation. By paying yourself a reasonable salary and distributing the remaining profits as dividends, you can maximize your income and retirement savings while ensuring compliance with the IRS.
When determining a reasonable salary, it’s essential to consider industry benchmarks and the reasonable compensation test. Additionally, working with a financial advisor can help ensure that you are making informed decisions for your company and optimizing your S corp salary.
Overall, by following the 60/40 rule and working with a financial advisor, you can ensure that your S corporation is operating within IRS guidelines and maximizing your income and retirement savings.
