Chances are you’ve seen something online about the potential tax savings of switching from an LLC to an S Corporation. If you’re wondering “how much to pay yourself from an S corp,” the short answer is that S Corporation owners should pay themselves a reasonable salary or reasonable compensation under IRS guidelines—high enough to support compliance, avoid audit trouble, and maximize retirement contributions, but not so high that they overpay Social Security taxes.
For entrepreneurs, small business owners, and anyone considering or already operating an LLC or S Corporation, that number is one of the most important inputs in the decision to make an S corp election, or corp election, using Form 2553. Many owners look at S Corp status for tax benefits and to avoid double taxation, but the salary piece is what determines whether those savings actually work in practice. Your reasonable compensation and total net profit drive the real comparison between entity choices, and they affect your payroll taxes, distributions, retirement savings, future Social Security benefits, audit risk, and the extra costs that come with running an S Corp.
This guide walks through how to set reasonable compensation, the IRS approaches used to evaluate owner pay, common salary myths, when LLC vs. S Corp tax treatment changes the math, and how misclassifying wages and distributions can trigger penalties.
Myths surrounding reasonable compensation
Many small business owners and corporation owners consider an S corp election or corp election for the tax benefits and pass-through treatment that helps avoid double taxation, but when setting pay there are several myths floating around about how to determine reasonable salary. Some say to take 50% of your profits as reasonable compensation and 50% as distributions, even though the Internal Revenue Service says the IRS requires a facts-and-circumstances approach for S corp owners and each s corporation owner rather than a percentage formula for an S corp reasonable salary or any corp reasonable salary. Some say to set your reasonable compensation at the Social Security maximum. And there’s plenty of other advice that’s not rooted in fact, such as a minimal salary, “just take $40,000 or $75,000,” or making the salary portion too low while taking large corp distributions or profit distributions instead of a salary comparable to the market.
The courts have been reliable in debunking these myths, although many accounting professionals and business owners still aren’t aware of the rules the IRS has established.
How S corp owners determine reasonable compensation
The reality is that the Internal Revenue Service requires owners who work in the business to pay themselves a reasonable salary before taking profit distributions, and it has determined three approaches that it deems acceptable to determine reasonable compensation. The most common approach among our clients is the Cost Approach, also known as the “Many Hats Approach.” This is based on the idea that you perform several different functions for your business and each function is entitled to a different cost.
In addition to choosing the correct approach, you’ll want to document your calculations for an S corp salary and make sure you’re using unbiased market data in those calculations. That means comparing pay at similar businesses, checking the market rate and market value for the role, and using labor statistics from the bureau of labor statistics or another comparable business source to support what someone in a similar role would earn. The IRS does not endorse percentage-based formulas for salary payments, so taking 50% of profits as wages—or relying on the 60/40 rule—is not approved. Bad advice often suggests paying yourself as little as possible, but a minimal salary while taking large distributions is a common audit risk, especially when it falls below what a comparable role would receive in similar businesses. If you don’t have reliable data to back up your calculations, or written compensation agreements where appropriate, you’re putting yourself at risk of a lengthy reasonable compensation IRS audit.
So, LLC or S Corp?
Once you have determined your reasonable compensation figure, you can calculate whether it’s more advantageous for you to be taxed as an LLC, Sole Proprietorship or S Corporation. Make sure that you consider the impact of payroll taxes, as well as the added cost of S corp payroll and corp payroll administration, since owner salary can be run weekly, biweekly, or monthly, whether you use payroll software or a payroll provider for ongoing compliance. Those employee wages are wages subject to payroll taxes, unlike distributions, and are subject to social security and medicare, including medicare taxes and federal unemployment tax, along with bookkeeping fees, state licenses, and similar costs. For payroll purposes, any shareholder working in the business is treated like any other employee.
What you pay yourself impacts payroll taxes and saving for retirement
Many business owners do not realize that, when comparing LLC, sole proprietor, and S corporation treatment, how much you pay yourself affects how business income flows to your personal tax return, and owners generally pay income tax on both salary and pass-through profits, including federal income tax and any state income tax. If you pay yourself too little through payroll, your retirement plan contributions will be limited and you may not have enough money to retire. The same is true with Social Security benefits. On the other hand, if you pay yourself too much through payroll, you risk overpaying your Social Security taxes.
S corp distributions can be more tax efficient than paying the owner entirely through wages because distributions are not subject to self employment tax or security and medicare taxes, while wages are, though you still owe income tax on pass-through business income. An S corp shareholder generally reports wages and distributions on a personal tax return, while the entity itself usually does not pay federal income tax directly. Health insurance and other fringe benefits can also be part of the owner’s compensation package and should be considered in tax planning. Therefore, you need to identify the “sweet spot,” where the amount you pay yourself through your business is “just right.” Legitimate business expenses can also affect that mix when they are properly handled. Not too low to trigger an IRS audit or underfund your 401(k) or SEP IRA. And not too high to overpay your social security taxes.
That balance also matters if a spouse works in the business for a lower salary, because the IRS still expects reasonable compensation and pay must satisfy minimum wage rules where applicable. The salary portion drives retirement contribution limits for active owner pay rather than passive income. Distributions exceeding stock basis are taxable as income and can increase your tax bill. Misclassifying distributions instead of wages can trigger back payroll taxes and IRS penalties, including penalties for non-compliance that can reach 100% of unpaid taxes or 20% plus interest. Some states, such as California, can also require state disability insurance. Tax credits also flow through the business return and can affect the owner’s overall tax planning.
Our CPA firm calculates this payroll sweet spot for our clients as part of our broader tax return preparation and planning services. Give us a call if you would like us to do the same for you!
In summary, while filing as an S Corp has the potential to save you thousands of dollars on your taxes, you need to fully understand what your reasonable compensation should be (and document that figure!) so you can protect yourself and your business should the IRS come knocking. In some cases, IRS penalties for misclassifying distributions can reach 100%.
Thank you to Paul Hamann of RC Reports for contributing to this article.
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Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include accounting services for small businesses and business tax preparation and planning.
