An S Corp reasonable salary can be determined in many ways. Generally, S Corp shareholders would rather be paid through dividends as opposed to wages because being paid through compensation requires shareholders to pay self-employment taxes whereas dividend distributions aren’t taxed. It is important for S Corp owners to be aware of the tax consequences if the IRS indicates that you aren’t paying yourself a reasonable salary for the work being conducted as a shareholder-employee of the business.

S Corp and Employment Taxes

Since S Corps operate as pass-through tax entities, the company itself doesn’t pay taxes. Rather, the profits and losses of the company are passed on to the shareholders (owners) of the business who report it on their personal tax returns. However, since the requirements for Social Security and Medicare payments has increased, so too has the employment tax burden on any company with employees.

In 2011, employers paid 6.2 percent of the first $106,800 of an employee’s compensation toward Social Security tax, while employees paid the additional 4.2 percent through withholdings. In 2014, however, employers paid 6.2 percent of an employee’s wages up to $117,000. If you are self-employed, then you are responsible for the entire 10.4 percent Social Security tax, along with the 2.9 percent Medicare tax on all of your income.

Since S Corp income isn’t subject to self-employment tax, there is a huge shift for shareholder-employees to reduce their salary and increase their dividend distributions, as such dividends wouldn’t be subject to payroll or self-employment tax. S Corps must report shareholder-employee salaries in the company’s receipts, if it totals $500,000 or more.

In order to do this, you will need to fill out Form 1125 and itemize the compensation for all employees, along with the percentage of time that each employee dedicated to the company. Also included is the percentage of stock owned by the person.

What is a Reasonable Salary?

In order to prevent S Corp shareholders from paying themselves through dividends and avoiding self-employment tax, the Internal Revenue Service (IRS) requires that S Corp shareholders who provide substantial services for the company be paid a reasonable compensation, meaning that they cannot simply earn money through dividend distributions.

With that said, there have been several legal disputes between S Corps and the IRS as to what constitutes a reasonable salary.

The IRS has specific guidelines on its website to help those shareholders and tax advisers determine what constitutes reasonable compensation. The following factors should be looked at when determining if the compensation is reasonable:

  • Training and professional experience
  • Responsibilities and obligations
  • Time devoted to the position
  • Dividend history
  • Payments made to non-shareholder employees
  • History of bonus amounts paid
  • What other businesses in the same industry pay for similar work
  • Compensation agreements between the S Corp and the shareholder-employee

Determining a Reasonable Salary

Owners of an S Corp have significant control over what they pay themselves – and how much they are paid through compensation and dividends. But the owner(s) must remember that the IRS will keep a close eye on how much of that money is given to oneself through wages versus dividends.

Owners of a C Corp, however, have to pay on such dividends as opposed to the compensation. Therefore, owners in a C Corp will want their pay to be in the form of wages as opposed to dividends, since the IRS will tax the dividends up to 23.8 percent.

An example of such ownership includes those operating in the dental and medical profession. In fact, most dental and medical practices operate as a C Corp, taking the profits out of the business at year-end and paying themselves a salary bonus, which is then taxed at the personal tax rate. C Corps will try to refrain paying out dividends since those are taxed at a higher rate.

Other Factors Courts Consider

While the IRS has the above-mentioned guidelines for businesses to consider when paying shareholder-employees, the courts will consider several additional factors, including the following:

  • How well the business is doing financially
  • Overall experience in the industry
  • Prevailing economic conditions of the industry in which the business operates
  • Other conditions, including the physical area where the business operates
  • How much another company would pay you for the same services

If you need help learning more about what a reasonable S Corp salary is, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.