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Why do shareholders need reasonable salaries?
Most corporations get taxed twice. The corporation pays income tax and the shareholders pay taxes on their share of the business income.
But S corps avoid this double taxation. Rather than being taxed at the corporate level and business owner level, taxes are only paid once: by the shareholders.
Additionally, shareholders in an S corp will not pay self-employment tax. These self-employment taxes are the same as payroll taxes employees pay on their earnings: taxes for Social Security and Medicare.
Instead, shareholders just pay income tax on their distributions.
This means if a shareholder holds a position in their S corp and opts to take little to no salary, they would avoid paying Social Security or Medicare taxes. The IRS rule on reasonable salaries closes this loophole.
Further reading: The Complete Guide to S Corporation Taxes
S corporation shareholders as employees
With early stage businesses, it’s common for shareholders to hold positions in their own company. Maybe the owner is the CEO or a shareholder is the head of product design. This is called being a shareholder-employee.
Since S corp shareholders don’t pay self-employment taxes, if these shareholders aren’t on payroll, the business and shareholder avoid paying taxes on labor provided.
Any shareholder-employees must be treated as an employee. They will need to:
- Be on payroll for the position they hold
- Be paid a reasonable salary
- Pay payroll taxes on the salary they collect
If a shareholder does not perform any services (or only minor services), they are not considered employees and do not need to be paid a salary.
Reasonable compensation for shareholder-employees
Because salaries are subject to employment taxes and distributions aren’t, shareholders want to minimize their salaries. This increases the S corporation’s net profits and therefore their distributions. To combat this, the IRS has their rule on reasonable compensation.
So what exactly is a reasonable salary? The IRS states, “the amounts [must be] reasonable compensation for services rendered to the corporation.”
This is far from the concrete answer shareholders might hope for. But, the IRS provides some factors to consider when deciding on reasonable compensation. These include:
- Training and previous experience
- Duties and responsibilities
- Time and effort devoted to the business
- Payments to non-shareholder employees
- What comparable businesses pay for similar services
When thinking about reasonable compensation, it’s best to approach the salary the same you would with a new employee. Take a look at related job listings to see what the market value is.
The U.S. Bureau of Labor Statistics provides access to average compensation in different fields based on experience. This comes with the added benefit of being a government reviewed report which will strongly back up your decision.
When in doubt, have a conversation with your CPA to decide what compensation makes the most sense given your situation.
What if a salary is determined as unreasonable compensation?
The IRS can audit the S corp’s form 1120S and each shareholder’s personal tax return.
If a salary is determined to be unreasonable during the audit, the IRS may request adjustments be made to all tax returns and filings. In addition to the costs of having these adjustments made by a CPA or tax professional, there’s risk of interest on the tax bill and penalties. S corps can be fined an accuracy penalty if the amount a shareholder is paid is 10% or $5,000 below market value.
Then there’s the case of payroll taxes. If a shareholder was underpaid and the amount is adjusted after an IRS audit, payroll taxes will be incurred on the increase in salary.
How to prove a salary is reasonable compensation
The information you need to prove you’ve paid a reasonable compensation to shareholders is unfortunately unclear. The guidelines provided by the IRS state that:
- The dollar amounts must be verifiable
- The taxpayer must be able to demonstrate the origin of the amount claimed (supporting documents or data)
- The taxpayer must be able to show that they entered the amount in good faith
Be ready to provide any documents or data you used to come up with the salary number. For example, save the job listings you looked at or any previous pay stubs you may have referred to. Think of it like your high school math class, you’re getting graded for showing your work just as much as the end result.
