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S Corporation Reasonable Salary: What Is It and How Much Is “Reasonable?”
The IRS says “S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made.” So, some salary must be taken ... but how much? And what is considered "reasonable?"
By Charles P. Elliott, CPA, and Peter T. Elliott, CPA
An S corporation does not pay federal income tax on its earnings each year. Rather, the earnings flow through to the shareholders who pay tax on those earnings at the individual level.1 These earnings, however, are not subject to self-employment taxes (Social Security and Medicare), a fact that may incentivize shareholders to mix their compensation between W-2 wages (subject to self-employment tax) and distributions (not subject to self-employment tax). For reference, the self-employment tax is 15.3%.
So why not incorporate, file IRS Form 2553, elect to be treated as a S corporation, and take all the corporation’s earnings out as distributions and pay zero self-employment tax? In short, the IRS states the following: “S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.” Also, per the IRS, “Under Section 7436 of the Internal Revenue Code, the IRS has the authority to reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes). Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which are subject to employment taxes.”2
Clearly, some salary must be taken; but how much? Well, it must be reasonable. OK, what is reasonable? What is reasonable given a certain set of facts differs for most people. I have reviewed some cases decided in tax court regarding reasonable compensation that shed little to no light on this discussion. In those cases, the S corporation shareholder took no or little salary, which can only be defined as piggish.3 So, we are back to “What is reasonable?”
Fortunately, the IRS has shared the following: “If most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation.” Now we must define “reasonable” and “most.” Is most 50%, or maybe 90%?
To add fuel to the fire, the Tax Cuts and Jobs Act (TCJA) implemented a deduction of up to 20% of qualified business income (QBI) for non C corporation taxpayers. To oversimplify (many mitigating factors exist), if your S corporation has a $100,000 profit, only $80,000 of it is taxed. While this QBI deduction, along with a decrease in tax rates and other changes, should be somewhat of a windfall for those in business; it incentivizes, again, S corporation owners to take less salary for the following reason.
Say your 100% owned S corporation will make $200,000 in profit prior to any W-2 wages paid to you. Normally, you would take $130,000 as W-2 wages and withdraw the rest as nonwage distributions; the $70,000 of remaining profit flows through to you and your taxable income is only $186,000 ($130,000 W-2 plus $56,000 ($70,000 multiplied by 0.8). Now, to increase your QBI deduction, you take only $75,000 in W-2 wages, leaving $125,000 as QBI, and your taxable income is only $175,000 ($75,000 W-2 plus $100,000 ($125,000 multiplied by 0.8), and you have saved 15.3% of self-employment tax on the decrease in wages. The combinations are endless, but you get the point.
So, how much salary should you take? Unfortunately, I do not have a finite answer. I have read articles, with which I generally agree, that state a good starting point is the maximum amount of wages subject to Social Security tax (increased to $132,900 in 2019) and go from there.
A word of caution: I find it difficult to believe this legislatively created area of potential abuse will go unnoticed by the IRS.
1 This blog assumes the individual is in a service business (lawyer, doctor, accountant etc.).
2 Veterinary Surgical Consultants PC vs. Commissioner, 117 T.C. 141 (2001).
3 Joseph M. Grey Public Accountant PC vs. Commissioner, 119 T.C. 121 (2002).
Charles P. Elliott, CPA, is president, chief executive officer, and owner of Charles P. Elliott PC in Cheltenham, Pa. He can be reached at cpe1@verizon.net.
Peter T. Elliott, CPA, CFE, is a certified public accountant at Charles P. Elliott PC. He can be reached at pelliott.cpe@verizon.net.
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