Reasonable compensation: setting a salary you can defend

What the rule says

The IRS's position is direct: an S corporation must pay reasonable compensation to a shareholder-employee for the services they provide before it makes non-wage distributions to them. The reason is money. Wages carry Social Security and Medicare tax; distributions don't. A salary set too low turns payroll tax into distributions, and that's what the rule prevents.

Two limits on it. It applies to owners who work in the business — an owner who performs no real services doesn't need a salary. And reasonable compensation never has to be more than what the owner actually takes out of the business: if you take nothing, directly or indirectly, there's nothing to reclassify.

What the IRS and courts look at

The IRS says the key is what you actually did for the business — looking at where its revenue comes from. If the revenue is your own work, most of the profit is compensation for it. The factors courts have used:

• Your training and experience
• Your duties and responsibilities
• The time and effort you devote to the business
• The business's history of distributions
• What it pays employees who aren't owners
• When and how bonuses are paid to key people
• What comparable businesses pay for similar services
• Any compensation agreements
• Whether a formula is used to set pay

Is there a 60/40 rule?

No. The 60/40 split — 60% salary, 40% distributions — and its cousins like 70/30 are rules of thumb repeated online. Neither the tax code nor the regulations contain any percentage. A salary that's 40% of profit can be reasonable for an owner whose business runs on employees, and far too low for one whose revenue is their own billable work. The split follows from the salary, not the other way round.

How a salary is set

The IRS's own guide for its valuation staff describes three ways to approach it, and a defensible figure usually leans on more than one:

• Market: what people in comparable jobs, in comparable businesses, are paid. Government wage surveys and industry salary data are the usual evidence.
• Cost: what it would cost to hire people for each role you fill — the owner who is also the salesperson, the bookkeeper and the lead technician — weighted by the time you spend on each.
• Income: whether, after your salary, the business still earns an investor a reasonable return. If paying you a market wage would leave nothing, your salary may already be too high, or the profit really is your wage.

What happens when it's too low

In Watson v. United States (2012), a CPA with twenty years' experience paid himself a $24,000 salary through his S corporation while taking roughly $175,000 to $200,000 a year in distributions. The court found $91,044 a year was reasonable pay for his work, and the difference was taxed as wages — payroll taxes owed on it, with interest and penalties. Watson's salary wasn't unreasonable because of a ratio; it was unreasonable next to what an accountant with his experience earned.

The file that defends it

• ○A description of your role, your hours, and how your time splits across what you do
• ○Comparable pay for each part of the role, with where the figures came from
• ○What you pay any employees who aren't owners, for context
• ○The salary decision recorded in the corporation's minutes, with the reasoning
• ○Payroll actually run: regular paychecks, withholding, a W-2
• ○A review each year, as the business and your role change

How it affects the rest of your taxes

• Payroll tax. A higher salary means more Social Security and Medicare tax, and a smaller saving from being an S corporation. The S corp calculator shows what a given salary does to the saving.
• The QBI deduction. Your salary doesn't count as qualified business income, so a higher salary usually means a smaller QBI deduction — though above certain income levels, the wages a business pays can also raise the limit on it. More on the QBI deduction.
• Health insurance. For an owner of more than 2%, premiums the corporation pays are added to your W-2 wages, free of Social Security and Medicare tax. How that works.

An example — and why it has no figure

Harbor & Pine, the fictional design firm in our sample report, projects $210,000 of profit and pays its owner a $78,000 salary. The comparable pay for the role is gathered and on file. But the report shows No figure yet and Professional review needed, because whether $78,000 is reasonable for this owner's work is a judgment call — and it's the owner's and their accountant's to make, not software's.

When it doesn't apply

• You don't work in the business, or do only minor services.
• You take nothing out of it — no distributions, loans or other payments.
• You're a sole proprietor or partner. Your profit is already subject to self-employment tax.

What salary is reasonable for you is a question for your CPA or tax attorney, and one worth revisiting each year.