If you formed an S corporation to save on self-employment taxes, you probably know that getting your S corporation salary right is critical. But, is your salary:

• Nonexistent?
  
• Too low?
  
• Too high?
  
• Just right?
  

Let’s dive into why getting your salary right matters and how to determine what it should be.

Setting your salary too low might sound tempting for saving on taxes, but if the IRS catches wind of it, you’ll face serious consequences:

1. Income & Self-Employment Taxes: The IRS will not only make you pay income taxes and self-employment taxes on the low salary, but they will also slap you with payroll tax penalties, which can add up fast.
   
2. Audit Expansion: When the IRS finds underreported salaries, expect an audit covering three years. This means penalties and additional income added for multiple years.
   
3. Stuck With a Higher Salary: If the IRS corrects your salary, you’ll likely be stuck with a higher salary moving forward, which defeats your original goal of reducing self-employment taxes.
   

How to Set a “Reasonable” Salary

Thankfully, the IRS has given us some help. The IRS Reasonable Compensation Job Aid provides a solid framework for determining what a reasonable salary is for your S corporation. While it’s not an official IRS rule, it’s an extremely useful guide to help you avoid the gray areas.

Let’s break down some of the methods you can use to determine your salary.

1. Market Approach

The market approach compares your S corporation to other businesses in similar industries. It asks the question: How much compensation would be paid for a similar position at a comparable company held by a non-owner in an arm’s-length relationship?

This is the approach the IRS favors, but the challenge is finding a perfect match for your role. Still, it’s a great place to start for setting a salary that aligns with industry norms.

2. Cost Approach

The cost approach is a more detailed method. It breaks down your work activities into components like:

• Management
  
• Accounting
  
• Finance
  
• Sales
  
• Marketing
  
• Advertising
• And many more…
  

By assigning hourly wages to these tasks, the cost approach calculates a total amount that reflects a reasonable salary for your position.

Here’s an example of how the cost approach could work:

Task	Hours	Wage	Amount
Taxi Driver and Chauffeur	104	$12.75	$1,326
General Manager	624	$58.32	$36,392
Wholesale Buyer	166	$27.59	$4,575
Collections Clerk	146	$15.32	$2,237
Sales Representative	624	$30.96	$19,149
Order Clerk	416	$18.56	$7,340
Totals	2,080	N/A	$71,019

In this example, a salary of $71,019 could be considered reasonable for an S corporation with $3.5 million in revenue and 19 employees.

3. Health Insurance & Pension Contributions

There are additional ways to lower your payroll taxes while boosting your compensation for tax purposes:

• Health Insurance: If your S corporation pays for health insurance for you and your family, it counts as compensation on your W-2. The good news? It’s not subject to payroll taxes, so it fits neatly into your strategy for reducing payroll taxes. 
• Pension Contributions: Contributions to a defined benefit plan, SEP plan, or 401(k) by the S corporation are counted as compensation but don’t trigger payroll taxes. This gives you a double benefit boosting your retirement savings and lowering your payroll tax liability. 
  • Planning Tip: Your salary determines how much your S corporation can contribute to your SEP or 401(k). A higher salary might allow for larger contributions. A defined benefit plan allows even higher contributions.
    

4. Section 199A Deduction

The net income from your S corporation passed through to you as a shareholder may qualify for the 20% Section 199A deduction on your Form 1040. This deduction can help reduce your taxable income, so getting your salary right can impact your overall tax strategy.

Setting a reasonable salary for your S corporation is crucial for minimizing tax risks and maximizing your savings. It’s about striking a balance between tax efficiency and compliance.

If you’re unsure whether your S corporation salary is right, I’m here to help!

 

Let’s review your compensation and ensure everything is in line with IRS guidelines. Feel free to reach out, and we can discuss the best approach for your situation.