Reasonable Compensation: The S-Corp Survival Guide
How to set an audit-proof salary that maximizes your S-Corp distributions and keeps the IRS satisfied.
The secret to the S-Corp savings.
The secret to S-Corp savings is a balancing act. The primary reason to elect S-Corp status is to save on self-employment taxes. You do this by paying yourself a salary (taxed at 15.3% for FICA) and taking the rest as distributions (taxed at 0% for employment tax). It is a strategy supported by IRS Fact Sheet 2008-25, and getting it right is the difference between wealth and an audit.
The IRS knows this. To prevent abuse, they require that your salary be "reasonable" for the services you provide. If it is too low, they can reclassify your distributions as wages and hit you with back taxes and penalties.
How to Set Your Salary
The IRS looks at several factors to determine if your compensation is reasonable:
- Training and Experience: Your specific expertise in the field.
- Duties and Responsibilities: What you actually do day-to-day.
- Time and Effort: Are you full-time or part-time?
- Comparable Salaries: What would a third party pay for the same work?
- Optimization Example: Shifting a $150k profit from 100% salary to a $60k reasonable salary saves $13,770/yr in FICA taxes.
The 60/40 Rule Myth
You may have heard of the "60/40 rule" (60% salary, 40% distribution). While this is a common rule of thumb, it is not found in the tax code. The IRS has successfully challenged 60/40 splits that were still deemed "unreasonable" given the high level of service the owner provided.
Audit Risks & Red Flags
- Taking distributions but paying $0 in salary.
- Paying a salary that is significantly lower than the industry average.
- A salary that has not changed despite business growth.
- Salary that is lower than what you pay your subordinates.
Documentation is Key
In an audit, the burden of proof is on you. You should maintain a "Reasonable Compensation Report" that documents the research you did to set your salary. This report should include job descriptions, Bureau of Labor Statistics data, and an analysis of your business's financial health. Consult a licensed professional to prepare or review this documentation.
See how this applies to your situation.
Consult a licensed professional before implementing any tax strategy. Individual results vary.
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