Are you paying yourself enough or too much? Considerations for S corps

S corporation (S corp) owners are in a unique situation when it comes to federal income taxes. The S corp is a special kind of entity that passes its corporate taxes through to its shareholders. Then, the shareholders report this as income on their personal tax returns and pay taxes on their total combined income at personal tax rates. An S corp officer, such as an owner, president, COO, etc., is considered an employee and the income they receive for their services are considered wages. These wages must be reasonable compensation, not cash distributions, payments of personal expenses, or loans.

But what is reasonable compensation?

The typical strategy for S corp owners to pay themselves less than the overall profits of the company and use cash distributions to take out the rest of the profits. The difficult part of the strategy is determining what reasonable compensation is. The IRS and the courts would say that is what it would cost to replace you. Obviously, the lower the salary, the lower the payroll taxes. Conversely, the higher the distribution, the higher tax audit risk.

Another strategy is considering a certain percentage of company profits that should go to owners’ salaries. Is, say, 50 percent a good number? Perhaps, but that depends on what your company profits are and what is a reasonable income for the owners. For example, if a company made $5 million in profits before owners’ salaries, and there were five owners, at 50 percent their salaries would be $2.5 million combined, or an average of $500,000 per owner, which may be more than reasonable compensation. But, if company profits were $300,000, 50 percent would be $150,000, or an average of $30,000 per owner, which would likely be too low.

The IRS guidelines suggest you look at the following factors to determine reasonable salaries for your corporate officers:

• 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 bottom line is that every company’s situation is different. If you’re uncertain about whether you are paying yourself (or your officers) enough or too much, talk to your tax advisor to determine the best amount for balancing the tax savings with the audit risk.

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