If you’re trying to determine a reasonable salary as an S-corporation owner, you might have heard of the 60/40 rule. Ignore this bad advice unless it works by accident.
What is the S-Corporation reasonable salary rule?
The S-corporation reasonable compensation rule or reasonable salary rule says that S-Corp owners must take a reasonable salary for the work that they do for the corporation.
The IRS doesn’t specifically define how to determine a reasonable salary. It depends on the situation.
Typically, reasonable salary means pay equivalent to what similar businesses pay employees for the same type of work.
For example, say that you’re a freelance software developer that has an S-corporation for federal income tax purposes. All of your work consists of writing and debugging code for outside clients.
Your clients pay you $200,000 per year. An employee doing the same type of work in the same number of hours would typically receive $200,000 per year. Therefore, your reasonable salary would generally be $200,000.
Yes, that means that when you’re a solo service provider, you generally have to take all or substantially all of your business income as reasonable employee compensation.
So when can small business owners with S-corporations actually claim dividends?
One example is if you’re a software developer who built a paid app. You’ll need to take a reasonable salary for the time you spend building and maintaining the app and taking care of other business tasks. If the app brings in more income above that, you can start taking dividends.
Basically, salary is for work that you personally do. Dividends are for work done by automation, passive or residual income for past work, or the profits on work done by your non-shareholder employees or contractors. For this reason, it can help to split up your different income sources in your accounting software instead of lumping everything together.
What’s the point of the reasonable salary rules?
If you formed an S-corporation, you probably did it to avoid payroll taxes on your income. You have to pay income taxes on your entire share of your S-corporation’s profit, but payroll taxes only apply to your wage income.
The IRS, of course, wants you paying taxes. You can’t just wave a magic wand and say none of your business income is subject to employment taxes.
You can use an S-corporation to reduce some of your payroll taxes, but the IRS wants you paying full taxes on a fair wage first.
Do all S-corp owners have to take a reasonable salary?
This is a bit of a trick question. The answer is that yes, all S-corp owners have to take a reasonable salary.
What’s reasonable depends on what each owner did. If an owner truly did no work for the corporation during the year, it’s possible that a reasonable salary for that owner is $0.
If an owner has at least some minimum involvement in management decisions or other aspects of running the business, he’s probably a shareholder employee that needs to receive at least a part-time wage. The wage might be much less than another owner who runs things day-to-day, but it still needs to reflect the type of work done and the hours worked.
What’s the 60/40 salary rule for an S-corp?
The 60/40 salary rule for an S-corp says that you take 60% of your income from the S-corporation as wages and 40% as shareholder distributions.
There’s also the 70/30 rule and 80/20 rule where you take 70% or 80% of your profits as wages.
What’s wrong with the 60/40 rule?
The problem with the 60/40 rule (and 70/30, 80/20, or whatever other number you use) is that it’s completely made up.
A long time ago, CPAs and S-corporation owners recognized that the IRS didn’t want S-corp owners taking all of their income as shareholder distributions. At the time, the IRS wasn’t too picky about what you claimed as reasonable compensation as long as you claimed something.
So CPAs decided on 60%, 70%, or 80% as a number that was enough to keep the IRS from digging deeper. But there was never an official safe harbor in the tax law where if you claimed at least X%, the IRS wouldn’t question your reasonable compensation calculation.
We’ve already talked about how reasonable salary is different for different types of businesses. It might be 100% for one and 10% for another.
So the reason that you shouldn’t use the 60/40 rule isn’t that the 60/40 rule went away or that reasonable salary calculations changed. The reason is that the IRS now pays a lot more attention to making sure S-corp owners pay employment taxes on a reasonable wage.
The IRS is also much more likely to audit S-corporations and ask you to show how you determined your salary. So if you use the 60/40 rule just because, you’re likely to face an IRS audit and have to pay additional federal taxes plus penalties.
How are you supposed to calculate a reasonable salary for an S-corp?
Determining a reasonable salary is mainly a matter of market research. You’re looking for what someone with similar skills and experience would get paid as an employee for similar work.
You’ll usually need to consider total compensation agreements such as paid vacations, health insurance, and other benefits. Geography can also come into play.
You should document how you determined your salary as an S-corp owner and save evidence. This can sometimes be as simple as getting average salaries from a service like Glassdoor or industry compensation surveys.
If you can sit across from an IRS agent with a straight face (and not just because you’re a good poker player) and explain how you determined reasonable compensation while showing supporting evidence, you’re probably good to go.
If your situation is more complicated where there is less available data to help you determine reasonable compensation or you’re trying to squeeze out every penny in tax savings, you can hire a CPA or Enrolled Agent to do an S-corp owner reasonable compensation analysis.
A reasonable compensation analysis follows the same principles we already discussed. The main difference is that you’re hiring a tax pro to do more research into industry data, tax law, and prior tax rulings.
Don’t wait until March or April to figure this out.
If this is your first year with an S-corp or you just realized you haven’t been doing things correctly, don’t wait until it’s time to prepare annual tax returns to think about reasonable compensation.
As a general rule, you need to record payroll transactions and pay federal quarterly payroll taxes throughout the year. You may also need to file state payroll taxes on a weekly, monthly, or quarterly basis.
Contact a tax advisor as soon as possible to make sure you’re on the right track.