If you formed an S corporation to save on self-employment taxes, your salary is a crucial part of that strategy. But how do you know if your S corporation salary is correct?
If your salary is:
- Too low – you could face penalties and back taxes.
- Too high – you might be overpaying in payroll taxes.
- Just right – you’re maximizing savings while staying compliant.
Here’s what you need to know to ensure your salary is set properly.
As both a shareholder and employee of your S corporation, the IRS expects you to take a reasonable salary. If your salary is too low, the IRS could impose significant penalties, back taxes, and interest. In some cases, the IRS may audit multiple years of returns, and once they adjust your salary, you’ll be locked into a higher amount going forward, erasing any tax savings you hoped to achieve.
Getting your salary right is critical to avoid unnecessary costs and maintain compliance.
What’s a “Reasonable” Salary?
The IRS provides guidance through its Reasonable Compensation Job Aid to help business owners determine what qualifies as a reasonable salary. While this document is not official IRS law, it offers a useful framework for determining a fair and defensible salary.
There are two primary methods used to calculate a reasonable salary:
The Market Approach
This approach compares your S corporation to similar businesses and looks at the compensation paid to individuals in similar roles. The question is: How much would a company pay someone in your position—if that person were not an owner of the company?
This is the IRS’s preferred method because it reflects real-world compensation trends and is based on market data.
The Cost Approach
The cost approach breaks down your various responsibilities (e.g., management, marketing, accounting, sales, etc.) and assigns a wage for each task. The total wages for these tasks make up your reasonable salary.
For example, a business with $3.5 million in revenue might have an owner’s salary calculated at $71,019 based on the hours spent performing key roles.
Additional Considerations: Health Insurance, Retirement, and Section 199A
When planning your S corporation salary, consider these additional factors:
- Health Insurance: If your S corporation pays for your health insurance, it counts as compensation but isn’t subject to payroll taxes. This can be a useful strategy to save on taxes.
- Retirement Contributions: Contributions made by the S corporation to your 401(k), SEP, or other retirement plans count as compensation but are not subject to payroll taxes. This helps maximize savings while increasing your overall compensation for retirement planning.
- Section 199A Deduction: Your S corporation’s net income, after reasonable compensation is deducted, may qualify for the 20% Qualified Business Income (QBI) deduction, reducing your overall taxable income.
Determining the right S corporation salary is an important part of your tax strategy. It ensures you’re maximizing savings while staying within the bounds of IRS regulations. At BASC Expertise, we help business owners navigate the complexities of S corporation salary and tax planning, ensuring that you make the most of your compensation while avoiding costly mistakes.
If you’re unsure whether your salary is appropriate, contact us today to schedule a consultation. Let us help you ensure your S corporation salary is both reasonable and strategic.
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