How to pay yourself in an S-Corporation?

According to the IRS, you need to pay yourself a reasonable salary.

But what in the world is a reasonable salary?

And shouldn’t you want to pay yourself the highest salary possible?

Like, why is this a thing?

Well, it’s a thing because by paying yourself a very low salary in an S-Corporation, you are effectively lowering the amount of taxes you pay.

And then, on the backend, you can pay yourself with distribution and not pay self-employment taxes because S-Corporations don’t have to pay them anyway.

So read till the end to learn the rules and stipulations regarding how to pay yourself in an S-Corporation.

In today’s post, we are going to fully explain how to pay yourself in an S-Corporation.

S-Corporations became a popular tax status because you do not have to pay self-employment taxes on its earnings, so long as you pay yourself a reasonable salary.

So let’s break this all the way down to make sure you understand this if you go this route.

What is an S-Corporation?

Let’s start by telling you what it is not.

An S-Corporation is not a legal entity.

When you form your business with your state, there is not an option for “S-Corporation”. You might be able to choose a partnership, LLC, or C-Corporation though.

An S-Corporation is a tax entity. We like to think of it as a tax status.

Why Elect an S-Corp Status?

Entities like LLCs and C-Corporations have the option to elect to be treated as an S-Corporation for tax purposes.

For example, a C-Corporation might choose to be treated as an S-Corporation to avoid double taxation, because they are taxed on both – a business and individual level.

While an S-Corporation is only taxed once on the individual level.

On the other hand, an LLC might choose S-Corp status to avoid self-employment taxes, because self-employment taxes do not apply to corporations.

Meanwhile, self-employment taxes do apply to all other pass-through entities, like sole proprietors, partnerships, and limited liability companies.

So by electing to be treated as an S-Corporation for tax purposes, you can limit your tax exposure and put that money in other places.

With that said, how should you pay yourself as an S-Corporation?

How to Pay Yourself in an S-Corporation

According to the IRS:

S-Corporations must pay reasonable compensation to a shareholder-employee, which is basically a shareholder who works in the business.

They go on to say that this compensation must be paid before non-wage distributions may be made to the shareholder-employee.

So basically, before you pay yourself or your partners a distribution of profits, you should be taking a reasonable wage from the business.

And for these wages, you will need to set up a payroll system to pay yourself through.

This is because the wage you pay yourself is subject to payroll taxes, like medicare, social security, state taxes, and individual taxes.

And although self-employment taxes are not assessed on S-Corporations, medicare and social security taxes are basically what self-employment taxes are for.

So in some sense, you are paying some type of “self-employment tax” if you are paying medicare and social security taxes.

But the good news is that you do not have to pay self-employment taxes on the business income. You’re only paying these taxes as wages.

For example, if your business made $150,000 in profit, and you paid yourself $50,000 in wages, then you would only pay social security and medicare taxes on the $50,000 you paid yourself in wages.

The remaining $100,000 would just be subject to federal and state income taxes.

So by electing S-Corp status, you would avoid a 15.3% tax on a big portion of your income.

But while the tax savings are pretty clear, what is not as clear is the whole “reasonable compensation” part.

What is Reasonable Compensation

This is what trips up most people in an S-corporation. They either pay themselves too little, or don’t pay themselves at all and just take distributions from their business.

This isn’t a surprise though. The guidance by the IRS is very gray when it likely should be black and white.

The IRS does not provide an exact amount or percentage of how much you should pay yourself in an S-Corporation, but they do give you some factors to consider.

Like the person’s training and experience, time devoted to the business, or what comparable businesses pay for similar services that the shareholder-employee provides.

So basically, consider how much you would pay an employee to perform the exact same job responsibilities that you perform.

For example, if you’re the CEO of your company, how much would you pay to hire someone as the CEO to run your business?

Considering that some CEOs make as little as $100,000 per year and some make as much as $50,000,000 per year, this might concern you.

But keep in mind that everything is relative to your company. The IRS is looking at the source of the gross receipts of your company.

In other words, your compensation should be reasonable considering the revenue your company makes and the portion of it that can be directly attributed to you.

The IRS says that payments should be classified as wages to the extent that gross receipts are generated by the shareholder’s personal services.

This might sound really good, but if you’re sitting there reading this post and really trying to figure this out, you might still be a little unclear on this.

So after reviewing some court cases and talking to other CPAs on this, let us give you a general rule of thumb to follow.

In general, reasonable compensation for a shareholder is about ⅓ of the net profits.

So if the business earns $100,000 after expenses, then a $30,000 salary may be considered reasonable.

Or a $100,000 salary if the business earns $300,000 in profits after expenses.

This, of course, may be modified based on your unique circumstances.

For example, if you’re only working in the business part-time, then perhaps you are really responsible for generating the gross revenue the company makes.

In this case, you might rationalize a lower salary to take as wages.

On the other hand, if you have no employees and literally run every aspect of the business…

…from sales to marketing to the delivery of your products and services, then you might take a slightly higher salary.

But ultimately, the general rule of thumb that almost every CPA we’ve talked to has been ⅓ of net income.

What do you think a reasonable salary is? Let us know in the comments below.

By the way, if you’re looking for reliable accountants to handle your business payroll, then check out our outsourced accounting services here.

We can take care of that, and more for your business. Contact us now!