Choosing a Business Entity: Determining S-corporation Reasonable Salary

This is an excerpt from a presentation I give to college students and to prospective entrepreneurs about types of business entities.

A college professor (who’s also an attorney) told me that my presentation on this subject is the best, clearest and most-concise overview of the topic that she’s ever seen.

I’m flattered by the compliment, and will try to translate those positives into a series of blog posts.

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What is a reasonable salary for a corporate owner? This is a tough question to answer because tax law and the IRS provide no formal definition of the term “reasonable.”

Facts and Circumstances

A salary that’s considered reasonable for one corporation may not be reasonable for another corporation. It depends on the facts and circumstances.

This page on the IRS website gives more information about S-corporation compensation issues. The keys the IRS mentions on that page are: how much of the corporation’s income is based on services provided by the shareholder; how much of the corporation’s income is based on services provided by employees; and how much of the corporation’s income is based on capital and equipment.

The more income that comes from services of the shareholder, the higher the salary should be.

Why is this a Big Deal?

In an S-corporation, only income classified as wages is subject to FICA taxes. Let’s look at the example from the last section in this series:

Joe the Window Washer runs his business as a sole proprietorship. His net income is $100,000. Joe will pay both income tax and self-employment tax on $100,000.

If Joe is an S-Corp, he could:

1.Pay himself a reasonable salary (say, $60,000). The salary is subject to income tax and FICA taxes.

2.Joe reports the remaining $40,000 as income subject to income tax but NOT to FICA or self-employment tax.

In this example, the FICA tax savings will be more than $5,000 by paying FICA on $60,000 instead of $100,000.

But you can also see the temptation Joe would have.

Why not push the salary down to $40,000? Then the FICA tax savings would be more than $8,000.

And then the temptation is to push the salary even lower. If Joe sets his salary at $20,000, the FICA tax savings are more than $11,000.

Of course, Joe should set his salary as low as is reasonable. The problem comes with defining “reasonable” — how low is too low.

The best way to figure it out is to determine what sort of work the owner is doing in the business, and what his or her salary would be doing comparable work as an employee. A website such as www.salary.com can help with that.