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S-Corp Reasonable Salary – Tips for Minimizing IRS Audit Risk

Michael Reynolds | April 13, 2023

[Prefer to listen? You can find a podcast version of this article here: E179: S-Corp Reasonable Salary – Tips for Minimizing IRS Audit Risk]

Owning a business comes with all sorts of challenges to navigate. This can include choosing the right entity and tax status.

Many businesses choose to be taxed as an S Corporation (or “S-Corp”) which has some advantages when it comes to taxation.

A quick refresher: an S-Corp is not a legal entity; it’s a tax election. An S-Corp is either an LLC or a C Corporation that has elected to be taxed under S-Corp status. Most small businesses find it most advantageous to establish an LLC as the legal entity and then file for S-Corp tax status when appropriate.

An S-Corp still retains “pass-through” taxation, which means that income from the business passes through to the personal tax return of the owner (similar to the taxation of an LLC).

So what’s the advantage of an S-Corp? Many business owners choose to elect S-Corp taxation because it can be more tax-efficient than a Schedule C status. In a Schedule C business (LLC or sole proprietorship) all income is subject to self-employment taxes. Self-employment taxes are Social Security and Medicare taxes that self-employed individuals must pay on their income. However, S-corp shareholders who are also employees of the company can take a portion of their income as a salary, and the rest as a distribution. Only the salary portion is subject to self-employment taxes, while the distribution portion is not.

With this in mind, it’s possible to reduce taxes by limiting the income paid through salary and maximizing the amount paid through distributions.

But there’s a catch – the IRS wants S-Corp owners to pay themselves a “reasonable salary” in the business. Otherwise, the owner could bypass 100% of self-employment taxes which is obviously not in alignment with the goals of the IRS!

As an owner of an S-Corp, it's important to determine a reasonable salary for yourself to avoid potential IRS audit risk. But how do you determine what is considered reasonable? Let’s explore the factors that go into determining a reasonable salary for S-Corp owners.

Understanding the IRS penalties for paying an S-Corp salary that is too low.

If the IRS determines that an S-corp owner's salary does not meet the guidelines of reasonable salary, the S-corp may be subject to penalties and fines. The IRS has the authority to reclassify distributions to owners as wages, which would increase the S-corp's payroll taxes and penalties.

Some of the penalties and consequences of not paying reasonable salaries to S-corp owners include:

  • Additional taxes: The IRS may reclassify distributions to owners as wages, which would increase the S-corp's payroll taxes and penalties. The S-corp may also be subject to interest charges on any unpaid taxes.
  • Penalties: The IRS may assess penalties for failing to pay employment taxes on reasonable compensation, including failure-to-file and failure-to-pay penalties.
  • Loss of S-corp status: If the IRS determines that the S-corp has not paid reasonable compensation to its owners, it may revoke the S-corp's status.
  • Audit risk: If the IRS determines that the S-corp has not paid reasonable compensation to its owners, it may trigger an audit of the company's payroll tax returns and other tax filings.

With penalties like these on the line, it’s clear that determining what is “reasonable” is something you want to be sure to get right as a business owner.

Guidelines for determining reasonable salary in an S-Corp.

First, it’s important to understand that while the IRS does provide some guidance for determining a reasonable salary for S-Corp owners, it is not exact. Rather, it’s a massive gray area with no specific or definitive answers.

This can be frustrating for business owners who want clear rules. It also opens the door to case-by-case interpretation and risk.

According to IRS guidelines, a reasonable salary is one that is comparable to what someone in a similar position would earn in a similar company. Factors that are taken into consideration include the owner's experience, education, and responsibilities, as well as the company's size and industry.

“Reasonable Compensation” considerations can include:

  • What do similar businesses pay for similar services?
  • What are the duties and responsibilities of the individual?
  • What sort of training and/or experience is required?
  • How much time and effort is devoted to the business?
  • Is there a formalized compensation agreement in place?
  • Is there a reasonable formula in place to determine compensation?
  • How profitable is the business?
  • Are location-based adjustments appropriate?

When determining a reasonable salary as an S-Corp owner, it's important to consider various factors such as the industry you operate in, your level of experience, and your job duties. For example, if you are the CEO of a large corporation, your salary will likely be higher than that of a small business owner with less experience. Additionally, if your job duties include managing a large team or overseeing complex projects, your salary should reflect that level of responsibility.

The time you spend in the business could also be a determining factor. If you work full-time in the business, then your salary would reflect that. However, if you are less involved and only work a few hours a week in the business, you may be able to justify a lower salary.

A good rule of thumb to use as a starting point is to ask the question: “If I were to fire myself today and hire a CEO to replace me, what would I pay that person?”

This can help you frame your compensation in a way that is logical and defensible.

Another tool that can help is the database offered by the US Department of Labor Bureau of Labor Statistics, which can be sorted by occupation and location.

Determining a salary range for a CEO of a small business is not an exact science. However, there are several additional tools and resources that can help:

  • Industry salary surveys: Many industry associations and organizations conduct salary surveys that provide data on CEO salaries for businesses of different sizes and in different regions. These surveys can provide a baseline for what CEOs in similar industries and regions are earning.
  • Job posting websites: Online job posting websites, such as Glassdoor and Indeed, provide information on salaries for CEO positions. This information is based on job postings and may not be as comprehensive as industry surveys, but can still provide a general idea of salary ranges (no endorsement or affiliation implied).
  • Compensation consultants: Compensation consultants can provide expert guidance on CEO compensation. They can conduct market surveys, analyze compensation data, and provide recommendations for salary ranges based on industry standards and other factors.
  • Small business resources: Small business organizations, such as the Small Business Administration (SBA), may provide information on CEO compensation for small businesses. They may also offer guidance on how to determine a reasonable salary range based on factors such as company size, industry, and location.
  • Tax and accounting professionals: Tax and accounting professionals can also provide guidance on CEO compensation. They can help small business owners determine a reasonable salary range and ensure compliance with all tax laws and regulations.

It's important to consider multiple sources when determining a salary range for a CEO of a small business. Small business owners should consult with a variety of resources to ensure that they are making informed decisions about what is reasonable compensation as owner of an S-corp.

It’s also worth noting that fringe benefits can count towards “reasonable compensation”. Certain fringe benefits are included in an S corp owner’s taxable income but are NOT subject to Social Security or Medicare taxes. These include:

  • Health, dental, and vision insurance premiums
  • Business-funded HSA contributions
  • Disability insurance premiums

Document your salary decisions and keep records.

One of the best ways to minimize the risk of an IRS audit is to document your salary decisions and keep accurate records. This includes keeping track of the factors you considered when determining your salary, such as industry standards and your job duties.

You should also keep records of any research you conducted to determine a reasonable salary, such as salary surveys or consultations with industry experts. By keeping detailed records, you can demonstrate to the IRS that your salary is reasonable and avoid any potential audit issues.

Avoid paying yourself an unreasonably low salary.

While it may be tempting to pay yourself a low salary in order to minimize payroll taxes, doing so can increase your risk of an IRS audit.

The IRS expects S-Corp owners to pay themselves a reasonable salary based on their job duties and industry standards. If you pay yourself an unreasonably low salary, the IRS may view this as an attempt to avoid payroll taxes and could trigger an audit.

Keep in mind that as stated before, there are no concrete rules from the IRS on this topic. It is a gray area. Therefore a lot of it comes down to your appetite for risk as a business owner.

On one hand, you can err on the side of caution and pay yourself a salary that is at the high end of reasonable in order to maximize your ability to defend your compensation in the event of IRS scrutiny. This means you may pay more in taxes but lowers your audit risk.

On the other hand, you may favor minimizing taxes as the highest priority. Going this route, you would need to be willing to accept the increased audit risk that may result. You may end up spending more time and effort defending your compensation. In some cases, you may even have a higher risk of penalties.

Only you can determine how aggressive or conservative you are in this area.

While S-Corp audit rates remain low, reasonable compensation is a common focus when it does happen. So if you do get audited, it’s likely that your compensation will be a target by the IRS for further scrutiny.

Consult with a tax professional for guidance.

When it comes to determining a reasonable salary as an S-Corp owner, it's important to seek guidance from a tax professional. They can help you navigate the complex tax laws and regulations surrounding S-Corps and ensure that you are paying yourself a fair and reasonable salary.

A tax professional can also help you avoid common mistakes that could trigger an IRS audit, such as paying yourself an unreasonably low salary or failing to document your salary decisions. By working with a professional, you can minimize your audit risk and ensure that your S-Corp is in compliance with all applicable tax laws.