What Is an S Corp?
An S corporation, or S corp, is a tax designation that can be elected by limited liability companies (LLCs) and corporations.
In order to elect to be taxed as an S corp, you must first make sure you are:
- A domestic corporation or LLC
- Have no greater than 100 shareholders (if a corporation)
- Shareholders must be US citizens, or legal residents of the United States
- All shareholders must be private individuals
With an S corp designation, members and owners are considered employees. As a result, they are paid a salary and may also take distributions from the company.
- Salary: The money you pay yourself through the S Corp. This is considered a wage and is subject to employment and income tax.
- Distributions: Profits and losses that pass through the S corp to the member. They are only subject to income tax, not employment taxes.
While distributions are tax-advantaged because you don’t pay employment taxes on them, you’re required to pay yourself a reasonable salary before taking distributions. Additionally, you can’t take an inappropriately small salary in order to collect more in distributions. Here’s an example of an S corp tax flow for an S corporation with $100,000 in annual profits:
While many LLCs and corporations may benefit from the tax advantages offered by an S corp, they must be sure to follow the rules outlined by the IRS.
Ready to start your S corp? We recommend using a formation service such as ZenBusiness.
What Is an S Corp Reasonable Salary?
When discussing S corporations, the terms “S corp reasonable salary” or “S corp reasonable compensation” will often come up. Essentially, a reasonable salary refers to the amount an S corp member pays themselves in salary. The IRS stipulates this salary must be reasonable; therefore, the compensation needs to reflect market standards and should be comparable to what you would offer to someone else who was doing your job. With an S corp, you are technically considered an employee, and your S corp must run payroll to compensate yourself and other employees with a salary that is subject to both employment and income tax.
While it may be tempting to pay yourself a smaller salary and take a larger distribution, the IRS is particularly mindful when it comes to S corps, and misfiling, even by mistake, can result in back taxes and penalties. They can also choose to tax your distributions as a salary subject to payroll tax.
S corporations can be complicated. We recommend using a service like Paychex to handle your Payroll and help keep your S corp organized.
When You Don’t Have to Pay an S Corp Reasonable Salary
A reasonable salary is generally based on the amount you would pay someone else for the same services, not profits or losses made by the company. That being said, there are situations where members of an S corp are exempt from paying themselves a reasonable salary.
You don’t have to pay a reasonable salary if:
- You aren’t taking distributions
- You cannot pay yourself the full reasonable salary (i.e, your net profit is lower than the figure for your reasonable compensation) — you can choose to not take a distribution, and receive wages until your reasonable compensation figure is met.
- You choose to take neither a distribution or a reasonable compensation (bearing in mind that if you wish to take distributions in the future, you have to pay reasonable compensation for the services you have provided in those years before you take distributions)
How to Determine a Reasonable Salary
It can seem daunting to try and set a reasonable salary for yourself, as the definition for a reasonable salary as stated by the IRS is relatively vague. Luckily, there are several factors you can use to determine a reasonable salary.
Some things to consider while setting a reasonable salary are:
- Your responsibilities and duties you perform
- Training and education (for instance, a candidate with a Masters degree in business can be expected to make more than someone with a Bachelor degree)
- Time with the company
- Dividend history
- Comparable salaries for businesses
- If you will be a part or full-time employee
- The location of your business (cost of living varies from city to city and can inform salary)
Resources for Choosing a Reasonable Salary
Finding examples of a comparable salary is a good way to gather information on what the market midpoint is for your job position. There are several resources where you can gather this information with relative ease:
- Glassdoor - an online resource where people can view information related to jobs and employees can give useful feedback and reviews of companies. One of the things Glassdoor features is company salaries posted by current and former employees. By looking at salaries for jobs comparable to yours, you can use that information to set a reasonable salary for yourself.
- Bureau of Labor Statistics - a government website with wage data from all over the United States. You can search by characteristic and difficulty of the job, state, or industry.
- A compensation consultant - someone whose job it is to design and implement compensation packages. They can do the research for you in regards to wage statistics and trends, so you can be confident your information is accurate and up-to-date.
Using the 60/40 Rule to Determine S Corp Reasonable Compensation
You may hear the term “60/40 rule” thrown around in discussions of reasonable salary. This refers to the idea that you take 60% of your revenue as salary and the other 40% as your distributions.
Although this may seem like a good rule of thumb, it’s actually just an arbitrary formula, and this strategy cannot be used to justify your salary to the IRS. It’s better to calculate your reasonable salary using the tools listed above and take into consideration the complex factors that contribute to a salary.
Paying Taxes on an S Corp Reasonable Salary
Like any salary, you will need to pay income taxes on the reasonable salary you take from your company. You will also pay payroll taxes or self-employment taxes on your salary since you are also a shareholder. At the end of the year, you can generally expect to file a:
- W-2 — Wage and Tax Statement: This reports an employee's income and all taxes withheld from their wages
- Schedule K-1 — Shareholder Share of Income, Deductions and Credits: This shows how much of the profits each owner is allocated.
- Form 1040 — US Individual Income Tax Return: This is your personal income taxes. On your individual tax return you will need to:
- Use your W-2 to report your S corp salary
- Use Schedule E of your personal income tax return to report and pay personal income taxes on distributions
Meanwhile, your company will file:
- Form W-3 — Transmittal of Wage and Tax Statements: A W-3 summarizes an employee's W-2 for the Social Security Administration
- Form 1120S — US Income Tax Return for an S Corporation: This is a reportage of the business’s income, gains and losses, tax credits and tax deduction
- Form 941 — Employer’s Quarterly Federal Tax Return: This is filed every quarter to report taxes associated with employees
- Form 940 — Federal Unemployment Tax (FUTA) Return: This document is for filing and reporting federal unemployment tax (FUTA)
Recommended: S corporation taxation is complex. Consider speaking with an accountant to help ensure your business fulfills its tax obligations.
S Corp Reasonable Salary Examples
Now that we’ve gone over some considerations when determining a reasonable salary, let’s look at some examples of what a reasonable salary may be in different situations.
Example 1: Higher Net Profit
You’re a member of a marketing S corp in Portland, Oregon. Your net profit is $125,000. Using Glassdoor, you see that the average salary of a digital marketer in your area is around $60,800 a year. You decide to pay yourself $65,000 for your wages, and take a distribution of around $60,000.
Example 2: Lower Net Profit
You’re an owner of a programming S corp in Los Angeles, California. Your net profit is $70,000 a year before your salary. Glassdoor tells you that the average salary of a programmer in Los Angeles is $76,156 a year. Since net profits can’t meet your reasonable salary, you choose to take out $71,000 for your salary and $0 in distributions. While this would not meet reasonable salary requirements, you won’t be fined for this because you are not taking distributions. You could also opt to leave all the money in your business and not compensate yourself, but you would need to make up for this by retroactively paying yourself in the future.
Is an S Corp Right for Me?
Electing an S corp tax designation can provide tax advantages and tax savings for an LLC or corporation whose net income is enough to pay its member(s) a reasonable salary. S corps do require you to file additional forms at the end of the year and are subject to increased scrutiny from the IRS. Diligence is a must when electing to become an S corp.
S corps are a great choice for those who would be making enough to cover their reasonable salary and have profits left over. Since these profits can be withdrawn as distributions, you will save a larger percentage in taxes.
Considering starting an S corp? We recommend speaking with an accountant to learn more.