How Much Salary Should an S Corp Owner Take?

How Much Salary an S corporation owner should take is a complex question requiring careful consideration of IRS regulations and court decisions. Navigating these complexities can be challenging, but HOW.EDU.VN provides expert guidance to ensure you meet your tax obligations while optimizing your financial strategy, offering unparalleled expertise. Understand the intricacies of S corp compensation and avoid potential pitfalls.

1. Understanding S Corporations and Reasonable Compensation

S corporations, as pass-through entities, generally avoid entity-level taxation, with income and attributes flowing to shareholders who report and pay taxes on their personal income tax returns. However, this structure creates an incentive for shareholder-employees to minimize their salaries in favor of distributions, which are not subject to payroll or self-employment taxes. The IRS closely scrutinizes these arrangements, requiring that S corporations pay shareholder-employees “reasonable compensation” for services rendered to prevent tax avoidance.

1.1 The Employment Tax Advantage and Its Potential Abuse

The employment tax advantage of S corporations over sole proprietorships, partnerships, and LLCs arises from Rev. Rul. 59-221, which states that a shareholder’s undistributed share of S corporation income is not treated as self-employment income. As employment tax burdens have increased, the incentive to minimize salary in favor of distributions has grown, leading to potential tax savings but also increased IRS scrutiny.

1.2 Examples of Salary vs. Distribution Scenarios

Example 1: A owns 100% of S Corp and draws a $100,000 salary. S Corp and A are liable for payroll taxes, totaling $13,300.

Example 2: A withdraws $100,000 from S Corp as a distribution. The distribution is not taxable, saving S Corp and A $13,300 in payroll taxes.

These examples illustrate the tax savings potential of distributions over salaries but highlight the risk of IRS challenges if the salary is deemed unreasonably low.

2. Historical IRS Challenges to Unreasonable Compensation

The IRS has a long history of challenging attempts by shareholder-employees to minimize compensation in favor of distributions. Landmark cases like Radtke and Spicer Accounting Inc. established the principle that shareholder-employees who provide substantial services to their S corporation must receive reasonable compensation subject to payroll taxes.

2.1 Key Cases and Rulings

Rev. Rul. 74-44: Imputed reasonable salaries to an S corporation that paid dividends but no compensation to shareholders providing services.
Radtke: Recharacterized dividends as wages subject to payroll taxes when the sole shareholder and director took no compensation.
Spicer Accounting Inc.: Ruled that a corporation’s sole full-time worker must be treated as an employee, subjecting distributions to payroll taxes.
Grey: Held that a shareholder providing significant services was an employee, and the accounting firm was liable for payroll taxes on independent contractor fees.

2.2 Government Scrutiny and Reports

Reports from the Treasury Inspector General for Tax Administration (TIGTA) and the U.S. Government Accountability Office (GAO) have highlighted the payroll tax advantage enjoyed by S corporations and the underreporting of shareholder compensation. These reports have led to increased IRS scrutiny and enforcement efforts.

TIGTA Report (2005): Found that single-shareholder S corporations often paid salaries equaling only 41.5% of profits and that many owners took no salaries despite generating significant income.
GAO Report (2009): Noted that S corporations underreported shareholder compensation by $24.6 billion in 2003 and 2004.

**3. A Rare Defeat for the IRS: The Davis Case**

In Davis, a district court rejected the IRS’s attempt to recharacterize distributions as arbitrary and capricious, holding that the shareholder did not provide substantial services to the corporation and met the exception from employee treatment in Sec. 3121 regulations. This case confirms that shareholders providing minimal services need not draw a salary.

**4. JD & Associates and Watson: Determining Reasonable Compensation**

Unlike cases where no salary was taken, JD & Associates and Watson involved shareholder-employees who drew both salaries and distributions. These cases focused on whether the compensation paid was reasonable given the services provided, offering a valuable framework for tax advisors.

**4.1 JD & Associates Case Analysis**

Jeffrey Dahl, the sole shareholder of JDA, an accounting firm, drew a salary of only $19,000 to $30,000 while taking distributions of $47,000 to $50,000. The IRS asserted that Dahl’s compensation was unreasonably low, citing his responsibilities as managing partner.

The IRS expert compared JDA’s financial ratios to those of comparable accounting firms using data from the Risk Management Association (RMA) and determined Dahl’s reasonable compensation to be $69,584 to $79,823. The court condensed nine factors into three groupings:

Employee Performance: Dahl’s performance was exemplary.
Salary Comparisons: Dahl’s salary was barely higher than his subordinates.
Company Conditions: The company had excess capital for employee compensation.

The court concluded that Dahl’s compensation was unreasonably low and upheld the IRS’s recharacterization of distributions to wages.

4.2 IRS Fact Sheet 2008-25

Following the JD & Associates decision, the IRS issued Fact Sheet 2008-25 to remind S corporations of the importance of paying reasonable compensation. The fact sheet summarized the factors considered by the courts and advised shareholders to carefully consider them when establishing their compensation.

**4.3 Watson Case Analysis**

David Watson, the sole shareholder of DEWPC, an S corporation, set his annual compensation at $24,000 while receiving distributions of $203,651 and $175,470. The IRS maintained that Watson’s compensation was unreasonably low and engaged the same general engineer used in JD & Associates to determine reasonable compensation.

The IRS expert used RMA data and surveys from Robert Half and the University of Iowa to determine that DEWPC was more profitable than comparable firms and that subordinate positions were paid significantly more. Using data from the AICPA’s Management of an Accounting Practice (MAP) survey, the IRS expert determined that reasonable compensation for Watson would be $93,000, grossing up the average director compensation by 33% to reflect Watson’s ownership interest.

The court agreed with the IRS, concluding that a reasonable salary would be $91,044 and reclassified $67,044 of Watson’s distributions as compensation.

5. Key Lessons from JD & Associates and Watson

These cases provide valuable lessons for S corporations and their tax advisors in determining reasonable compensation for shareholder-employees.

5.1 Nature of the S Corporation’s Business

Professional services corporations, such as law, accounting, or consulting firms, are more likely to face IRS scrutiny because profits are primarily generated by the personal efforts of the employees. In these businesses, a significant portion of profits should be paid out in compensation rather than distributions.

5.2 Employee Qualifications, Responsibilities, and Time Devoted to Business

A thorough understanding of the shareholder-employee’s services is essential. Shareholders providing limited services need not draw a salary, while those with greater experience, responsibilities, and effort should receive a larger salary.

5.3 Comparison with Nonshareholder Employees or Amounts Paid in Prior Years

Salaries should be logical and consistent with the responsibilities and experience of the shareholder-employee. Significant discrepancies, such as paying shareholder-employees less than subordinates or failing to increase salaries with rising revenues, may raise red flags.

5.4 What Comparable Businesses Pay for Similar Services

Benchmarking tools from sources like monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data can help determine the relative reasonableness of compensation compared with industry norms.

5.5 Compensation as a Percentage of Corporate Sales or Profits

Financial ratios published in the RMA and industry-specific publications like the MAP can help determine the corporation’s overall profitability and the shareholder-employee’s compensation as a percentage of sales or profits.

5.6 Compensation Compared with Distributions

While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that an S corporation pay out all profits as compensation. However, setting compensation below the Social Security wage base may invite greater IRS attention.

5.7 Can a Shareholder Forgo Both Salary and Distributions?

While the IRS has indicated that there is no requirement to pay compensation if a shareholder-employee forgoes distributions, it is prudent to encourage profitable S corporations to make reasonable salary payments.

6. The Future of S Corporation Reasonable Compensation

S corporation reasonable compensation remains a hot issue. Proposed legislation and reports from government agencies have suggested imposing self-employment tax on the undistributed income of shareholders. As the limitation on Social Security wages subject to payroll tax continues to increase, the likelihood of abuse may also increase.

6.1 Proposed Legislation and Reports

The 2005 TIGTA report recommended imposing self-employment tax on the undistributed income of shareholders owning more than 50% of an S corporation’s stock.
The GAO report posed alternatives for S corporation reform, including imposing self-employment tax on the undistributed income of all shareholders.
The House of Representatives passed legislation in 2010 that would have subjected all undistributed income of professional service S corporations to self-employment tax, though it died in the Senate.

6.2 Potential Changes in Social Security Wage Base

If Congress were to remove the limitation on the amount of Social Security wages subject to payroll tax, the likelihood of abuse would only increase, making reasonable compensation even more critical.

7. Expert Guidance from HOW.EDU.VN

Determining reasonable compensation for S corporation owners is complex, requiring careful consideration of numerous factors and potential pitfalls. Navigating this landscape alone can be daunting, leading to costly mistakes and IRS scrutiny. At HOW.EDU.VN, we connect you with a team of over 100 renowned PhDs and experts worldwide who provide personalized guidance to ensure you meet your tax obligations while optimizing your financial strategy.

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7.2 HOW.EDU.VN’s Team of Experts

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9. Navigating Reasonable Compensation: Five Key Intentions

When grappling with the question of “how much s,” S corporation owners typically have five key intentions driving their search for information and guidance:

Compliance: Ensuring adherence to IRS regulations and avoiding penalties.
Optimization: Maximizing tax savings while remaining compliant.
Fairness: Determining a compensation level that is fair to both the shareholder-employee and the corporation.
Benchmarking: Understanding industry standards and comparable compensation levels.
Risk Mitigation: Minimizing the risk of IRS scrutiny and potential audits.

HOW.EDU.VN addresses these intentions by providing expert guidance, personalized solutions, and ongoing support to help S corporation owners navigate the complexities of reasonable compensation with confidence.

10. FAQs: Determining Reasonable Compensation for S Corp Owners

What is reasonable compensation for an S Corp owner?

Reasonable compensation is the amount of salary an S corporation owner-employee should receive for services provided to the company. It must be high enough to reflect the value of the services performed and comparable to what would be paid to an unrelated employee for similar work.
Why is it important to pay reasonable compensation?

Paying reasonable compensation ensures compliance with IRS regulations, avoids penalties, and prevents the reclassification of distributions as wages, which would be subject to payroll taxes.
How do I determine reasonable compensation?

Consider factors such as the owner-employee’s qualifications, responsibilities, time devoted to the business, industry benchmarks, and the company’s financial performance. Consulting with a tax professional or using resources like HOW.EDU.VN can also help.
What happens if I don’t pay reasonable compensation?

The IRS may reclassify distributions as wages, subjecting them to payroll taxes. You may also face penalties and interest on unpaid taxes.
Can I forgo a salary and take only distributions?

While technically possible if you provide minimal services, it’s generally not advisable, as it can raise red flags with the IRS. It’s best to consult with a tax advisor to determine the appropriate compensation level.
What records should I keep to support my compensation decisions?

Maintain records of your job duties, time spent on the business, industry research, and any other factors considered when determining your compensation.
How often should I review my compensation?

Review your compensation annually to ensure it still reflects the value of your services and remains compliant with IRS regulations.
What are some red flags that might trigger an IRS audit?

Red flags include taking minimal salary while receiving large distributions, failing to increase salary with rising revenues, and paying yourself less than subordinate employees.
Is there a specific formula for calculating reasonable compensation?

No, there is no specific formula. The determination is based on a variety of factors and requires professional judgment.
Where can I get help determining reasonable compensation?

Consult with a tax professional, CPA, or business advisor. Resources like HOW.EDU.VN offer expert guidance and personalized solutions to help you determine the appropriate compensation level for your specific situation.

11. Connect with Experts at HOW.EDU.VN

Don’t navigate the complexities of S corporation compensation alone. Contact HOW.EDU.VN today to connect with our team of renowned PhDs and experts worldwide. We provide personalized guidance to ensure you meet your tax obligations while optimizing your financial strategy.

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