What Is an S Corp?
An S corporation (S corp) is a tax classification available to some limited liability companies (LLCs) or corporations. With an S corp designation, the Internal Revenue Service (IRS) considers the company’s owners (or members) employees by law. The owners (members) of an S corp generally receive money from the company in two ways: as a reasonable salary and by collecting distributions.
Distributions and Reasonable Salary
As mentioned above, S corp owners (members) can receive money from their company in two ways:
- Distributions: These are the profits and losses accrued by the company that it then passes on to its members.
- Reasonable Salary: This functions essentially the same as any salary or wage you might collect.
Your reasonable salary is subject to both income and payroll taxes whereas your distributions are only subject to income tax. While the IRS doesn’t provide guidelines as to how you should calculate these numbers, there are some good tools and general wisdom that can help you in making these decisions.
What Are Distributions?
Distributions are profits and losses passed through a company to its shareholders or owners that aren’t considered wages. Distributions are only subject to income tax and thus offer shareholders/owners an opportunity to save money on their taxes. Companies distribute them to shareholders/owners based on their ownership percentage or the business’s Operating Agreement.
Advantages to Taking Distributions
One of the primary benefits of electing S corp status is the ability to withdraw profits from your company without facing the additional taxation a salary would incur. This is because only federal and state income taxes apply to distributions.
The other key benefit is the flexibility distributions can offer. Because you aren’t required to take them, you can grow your business and keep your net profits in the company or your salary if you so choose.
Example: A user interface (UI) designer in Austin, Texas, is the sole member of an S corp that earns around $130,000 per year in net profits. This individual chooses to take all of this and takes a reasonable salary of $95,000 per year along with $35,000 in distributions. Their salary of $95,000 is taxed at around 15.3%, using both payroll and self-employment taxes, and it also faces income taxes. But, the IRS only taxes their $35,000 in distributions once at around a 7% income tax rate.
S Corp Distribution Taxes
The IRS taxes distributions differently than the wages you’ll take from an S corp. When taking distributions, you — or your company — must file the following:
- Schedule K-1 — This document lists what each shareholder in a company made in profits or losses. If you took distributions from your S corp, you must report them on your Form 1040 when filing your Form W-2.
- Form 1040: US Individual Income Tax Return — This is your personal income tax return, where you’ll need to:
- Use your Form W-2 to report your S corp salary; and
- Use Schedule E to report and pay personal income taxes on your distributions.
- Form 1120S: US Income Tax Return for an S Corporation — The company must file this document to report its income, gains and losses, tax credits, and tax deductions.
- Form W-2: Wage and Tax Statement — You’ll also receive or file this form, which reports an employee's income and all taxes withheld from their wages.
What Is a Reasonable Salary?
A reasonable salary refers to the amount an S corp member pays themselves in wages. If you plan to take a distribution from your company, you must first pay yourself a reasonable salary before collecting any additional profits.
Your salary will be subject to payroll and self-employment tax (15.3%) as well as income tax. Because payroll and self-employment taxes don’t apply to distributions, the IRS carefully scrutinizes reasonable salary payments to verify S corp members don’t take less than they should.
All S corps must run payroll in order to pay out reasonable salaries. We recommend using Paychex for your payroll services.
What Are Some Factors When Determining a Reasonable Salary?
As previously noted, the IRS doesn’t tell you exactly how to determine your reasonable salary — and it’ll differ from person to person. A good starting point for determining a reasonable salary is to pay yourself what you might pay someone else to perform the job you do.
Here are several resources you can use to determine this:
- Glassdoor: This online resource enables people to view information related to jobs, including company salaries posted by current and former employees. By reviewing salaries for jobs comparable to yours, you can use that information to set a reasonable salary for yourself.
- US Bureau of Labor Statistics: This government website provides wage data from across the country. You can search by job characteristics, difficulty, state, or industry to find a comparable position to yours.
- Compensation Consultant: This type of professional specializes in designing and implementing compensation packages. They can do the research for you regarding wage statistics and trends so that you have the most up-to-date information.
You also should consider key factors of your employment, including:
- Your time involved with the company
- Your years of experience
- Whether you’re a full-time or part-time employee
The 60/40 Rule
A common concept used when discussing reasonable salaries and distributions is the “60/40 rule.” It stipulates that you can calculate a reasonable salary and distribution ratio by taking 60% of your net profit as salary and 40% as distributions. While this may seem like a good rule to follow, it’s not something the IRS uses to evaluate reasonable salaries. That makes it better to calculate your reasonable salary and distribution rate by using the resources and other key factors noted above.
Example: A member of a graphic design S corp in Portland, Oregon, with a net profit of $60,000 per year would take $36,000 in salary and $24,000 in distributions by following the 60/40 rule. However, the median salary for a graphic designer in this area is closer to $55,000 per year. If you use the 60/40 rule, you’ll come to a salary figure that falls below the median and won’t pass IRS scrutiny.
Do I Have to Pay a Reasonable Salary?
If you don’t plan on taking a distribution from your company or you can’t pay yourself an appropriate rate, you don’t have to pay yourself a reasonable salary.
Example: You operate a small advertising S corp in Los Angeles, California, with net profits of $100,000 per year. But, the median salary for an advertising professional in this city is closer to $130,000 per year. In this case, you can’t pay yourself a reasonable salary. If you don’t take any distributions, you can pay yourself an annual salary of $90,000 without facing potential problems from the IRS.
If you still have questions about how to pay yourself as an S corp, consult with an accountant today.
Benefits to Paying Yourself as an S Corp
While S corps do carry increased scrutiny and complications come tax season, they also enable their owners to reap the benefits of a growing business through distributions. Moreover, S corp status ensures the owners receive a reasonable and fair wage. You may, therefore, find the tax benefits worthwhile for designating your business as an S corp and potentially collecting distributions in addition to your salary.
Still unsure if an S corp is good for you? Check out our S Corp Advantages and Disadvantages guide to learn more.