A business-of-one often elevet to be treated as an S Corp instead of a sole proprietorship for tax purposes, because of the sweet tax savings you can reap from the status.
But, to stay above board with the IRS while making the most of those tax savings, you have to be careful about exactly how you pay yourself.
An S Corp owner has to receive what the IRS deems a “reasonable salary” — basically, a paycheck comparable to what other employers would pay for similar services. If there’s additional profit in the business, you can take those as distributions, which come with a lower tax bill.
Like anything involving taxes in the U.S., it’s complicated. So here’s a simple-as-it-gets guide to paying yourself a reasonable salary in an S Corp.
S Corp distributions vs. salary
When you organize your business as a legal entity, like a LLC or corporation, you become its employee — even if you’re the only one in the business. For tax purposes, you can file as an S Corp to keep your taxes (relatively) simple and claim the profits on your personal tax return, instead of paying corporate taxes.
In accounting speak, you earn money two ways when you own a business:
- Distributions are the profits (and losses) that pass through the S Corp to you as an owner (shareholder). Distributions are not your employee wages and are not treated as self-employment income.
- Salary is the money you pay yourself as an employee of the S Corp — your employee wages or reasonable compensation.
It’s a little odd to think about distributions as a business-of-one, because the business’s profits are generally all your income. But you distinguish how you receive that income, because they have different tax implications.
- You don’t have to pay payroll taxes on distributions from your S Corp.
- You have to pay payroll taxes on your salary, like any other employee.
Payroll taxes are a 15.3% tax on income that covers Medicare and Social Security (separate from your income tax). It can add up fast! So any income you take as distributions rather than salary saves you that cost in taxes.
To curb the obvious temptation to take all your earnings as distributions rather than salary, the IRS sets a basic guideline: You have to pay yourself a “reasonable salary.”
A reasonable salary is a must
The IRS requires S Corp shareholder-employees to receive a reasonable employee salary, which it generally defines as at least what other businesses pay for similar services.
Evading taxes by disguising your salary as a distribution could get you serious penalties, on top of a big back-tax bill, if an IRS audit recharacterizes your income as salary. You could pay tax penalties of up to 100%, plus negligence penalties.
What is a reasonable salary for an S Corp?
It’s up to you to decide how much employee salary to pay yourself versus how much to take as distributions. Which might sound exciting, except you have to make sure it jives with the IRS rules.
Here’s a general rule to follow: Reasonable pay is the amount that similar enterprises would pay for the same, or similar, services. What do workers in your role tend to get paid under employers? Or, if you were employed in a similar role before, what was your salary as an employee?
The rule isn’t spelled out explicitly in tax law anywhere; instead, the vague guideline has been interpreted through court cases. That adds some extra fun to your compliance effort!
Here are some of the factors the IRS considers to determine whether you’re paying yourself a reasonable salary through your S Corp:
- Training and experience.
- Duties and responsibilities.
- Time and effort devoted to the business.
- Dividend history.
- Payments to non-shareholder employees.
- Timing and manner of paying bonuses to key people.
- What comparable businesses pay for similar services.
- Compensation agreements.
- Use of a formula to determine compensation.
The key to establishing reasonable compensation, according to the IRS, is determining what you do for the company. Are you providing direct services or employing others to provide them?
- If most of the business’s income comes from your direct services, the IRS expects you to receive most of the business profit’s as employee salary and bonuses.
- If most of the business’s income comes from services performed by non-shareholder employees and contractors, or capital and equipment (e.g. interest earnings on loans or selling company vehicles), the IRS considers it reasonable for you to get distributions along with your salary.
Note: The “reasonable salary” requirement for S Corps only comes into play if you (and other shareholders) take distributions from the company’s profits. The IRS can’t impose a minimum salary requirement, so don’t fret if your business isn’t earning enough yet to pay yourself a salary comparable to others in your field.
Not sure where to start? Base your pay on industry statistics to land on something comparable to what others are paid.
Find stats about employee pay through:
- Bureau of Labor Statistics: This free source of information lists highly detailed salary information for 800 occupations.
- Employer-review sites, like Glassdoor, Salary, and PayScale, crowdsource employee compensation information by company, position, industry and location.
RCReports: Purchase a report from this company designed with the express purpose of reasonable compensation analysis.
What if you wear multiple hats?
Small business owners usually perform multiple jobs, because a lot needs to get done to keep a business running every day.
For example, the owner of a one-person web development company might spend 75% of their time doing web development, and 25% of their time doing admin and marketing work.
Those jobs tend to be paid at significantly different rates.
You could check out salary information for each role you fill and combine the rates. But this will be complicated. It’s easier to just look for the closest single role you can find — most likely, the kind of work you spend most of your time doing.
Making adjustments to figure out your ideal salary
Landing on a comparable salary is a good start, but it might not make sense for your business to pay yourself that salary. Take your business’s unique circumstances into account to make adjustments toward a reasonable salary for your situation.
For example, you might adjust the salary downward if:
- Your business is less profitable than other similar businesses in your area.
- You work part time (less than 2,080 hours annually).
- You can attribute the success of your business to factors other than your personal efforts, like assets you purchased or people you employ.
Once you decide on your employee compensation, make it a point to document how you arrived at the amount, and keep copies of the salary stats that you used to set your salary. Those records could come in handy in case of an audit.
Note: The IRS won’t object if your S Corp pays you nothing if your business is earning little to no income. However, when your S Corp starts making money, the first thing you need to do is pay yourself reasonable employee compensation. If there’s money left over after that, you can pay yourself distributions.
What about the S Corp 60/40 rule?
A commonly touted strategy to set your S Corp salary is to split revenue between your salary and distributions — 60% as salary, 40% as distributions.
However, the salary you end up with this kind of rule is arbitrary and may not pass muster with the IRS. You could pay more in taxes than necessary, risk penalties for low-balling your pay or end up with unused money in the company.
Instead of following a revenue-based strategy, calculate your reasonable compensation based on your unique facts and circumstances, like the details we covered above.
S Corp salary examples
Let’s try a hypothetical example to show you how an S Corp salary might look.
Say Athena is a freelance technical writer who formed an LLC taxed as an S Corp. It’s a business-of-one, so she’s the company’s sole shareholder and employee. Her business profit is $120,000 per year. The Bureau of Labor Statistics shows the median salary for technical writers is $78,590.
Athena’s company pays her $78,000 in employee salary and bonuses, and a $42,000 shareholder distribution, saving her about $5,000 in payroll taxes compared to operating and being taxed as a sole proprietorship.
S Corp salary examples from IRS data
Until 2013, the IRS released annual reports that included average S Corp salary information. This spans industries and ignores any nuances of your particular situation, but could give you a rough idea of what the IRS sees as a reasonable salary.
IRS S Corp case examples
Not convinced you have to worry about a reasonable salary? Here are two real-life examples that demonstrate the importance of paying attention to this requirement:
- An accountant in Arkansas was paying himself no salary and $83,000 in distributions. In an audit, the IRS used information from a large financial services recruiting firm to determine a reasonable salary for an Arkansas CPA to be between $45,000 and $49,000, and the accountant faced back-taxes and penalties. (Barron v. Comm’r, T.C. Summ. 2001-10.)
- A CPA in Iowa paid himself a $24,000 annual salary and received $220,000 in distributions as the sole shareholder of his firm. The IRS determined that the CPA had not paid himself a reasonable salary and treated $175,000 of his distribution as salary subject to payroll tax. (Watson v. United States, (DC IA 05/27/2010) 105 AFTR 2d ¶ 2010–908.)
Decide how to pay yourself from an S Corp
Keep these points in mind when deciding how much to pay yourself from your S Corp:
- Your total employee compensation includes salary and bonuses, as well as health benefits listed as wages on your W-2.
- Not paying yourself any salary while your business earns money is a big red flag for an IRS audit. (Translation: Don’t expect to get away with it.)
- Minimum wage requirements are totally different from reasonable salary requirements. If you operate in a professional field, paying yourself minimum wage likely won’t make the cut at tax time.
Tip: The IRS is most likely to audit you if you’re taking shareholder distributions without a salary.
How to make salary payments to yourself
Once you organize your business as a legal entity, like an LLC, paying yourself gets more complicated than just collecting money from clients or customers. You need to operate like a business with employees, even if you’re the only one on the payroll.
A few things to keep in mind when you set up payroll for your S Corp:
- Your company pays half of your payroll taxes (7.65%) from its own funds, withholds the other half (7.65%) from your pay and sends the entire amount to the IRS as a tax payment.
- Your company sends a W-2 form to the IRS each year, showing how much you were paid. It also files an annual employment tax return.
- Your company has to pay unemployment taxes on your behalf. The federal unemployment tax (FUTA) is 6% of your first $7,000 in pay, and your state might require you to pay state unemployment tax, too.
- Your company might have to provide workers’ compensation coverage, depending on your state requirements.
- Your company might have to pay a state disability insurance (SDI) payroll tax, in some states, including California and New Jersey. One-owner corporations can opt out of SDI in California.
S Corp salary frequency
It’s up to you to determine how often to pay yourself an employee salary. It might be once or twice a month, once a week, every other week or less often.
Some S Corp owners pay themselves a salary only once annually, at the end of the year. But it’s wise to pay yourself at least quarterly, because your business might have to make quarterly payroll and income tax payments, and file quarterly employment tax returns.
If you ever need more money, you can take a shareholder distribution at any time. That can be a simpler and more tax-efficient way to boost your income periodically, because you won’t withhold taxes on distributions, and pulling money this way is simpler than constantly changing your employee salary and recalculating payroll taxes and employment tax every time.
Tip: You don’t have to pay yourself the same salary every payday. You could pay yourself a relatively small salary every quarter and then pay yourself a substantial year-end bonus, for example.
S Corp payroll services
Real talk: Complying with all the tax requirements, as well as all of the other legal requirements that come with running a business, can be super complex and confusing.
If you want more comprehensive financial support, Collective can take the guesswork out of this for you. We not only organize and maintain your S Corp tax status but also maximize your tax savings by helping you figure out exactly how much to pay yourself.
With Collective, you get access to our team of experts, including a CPA who helps with all the scary tax and legal stuff, like calculating paychecks and submitting quarterly tax payments.
Reporting your S Corp salary on your taxes
Just like any other employee would, you have to report your salary on your taxes.
Your company compiles a W-2 form by Jan. 31 each year, which shows you your total employee wages for the previous year. You report that amount as income on your Form 1040 when filing your tax return for the year.
Your W-2 does not include your distribution income from the company.
Instead of a W-2, your S Corp files IRS Form 1120S, U.S. Income Tax Return for an S Corporation to report your distributions. This form is an information return that reports your business’s income, deductions, profits, losses and tax credits for the year. It also includes a Schedule K-1 for each shareholder.
Schedule K-1 shows each shareholder’s share of the company’s profit or loss. If you’re the only shareholder, your share will be 100%.
Any profit your business had at the end of the year passes through the company and is taxed through your individual tax return. Your company doesn’t pay income tax itself. All the profits it earns pass through the business to shareholders’ individual returns.
You report your share of the business’s net profit or loss from your Schedule K-1 on your Form 1040 when filing your tax return for the year.
Tip: Have a tax pro complete your company’s Form 1120S and Schedule K-1s to ensure accuracy.
Yes, you pay tax on distributions
This is a little confusing, because you don’t withhold payroll taxes — that 15.3% we mentioned, a.k.a. self-employment tax — from your distributions. But you will, in fact, still owe income tax on that income.
And if the total income tax you’ll owe on self-employment income is $500 or more, you can’t wait until April 15 to pay all of it at once. You need to make estimated quarterly tax payments.
Worried about underestimating or forgetting to pay quarterly taxes? You can always boost the withholding from your employee salary to cover that obligation throughout the year.
FAQs about S Corp salaries
An S Corp can have up to 100 shareholders, and all must be United States residents. Each of these shareholders can receive distributions for their share of the company’s profits free from payroll taxes, as long as they’re receiving a reasonable salary for their work at the company.
No — the IRS can’t require a minimum salary for self-employed workers. The requirement only comes into play if you’re paying distributions to shareholders.
How are S Corp distributions taxed?
S Corp distributions are taxed as personal income. After salaries and other expenses, the company’s profits are passed through to shareholders and reported on individual income tax returns. If you’re a business-of-one, you’ll report all profits after your salary on your income tax return.
Can an S Corp owner collect unemployment?
Because you pay yourself a wage as an employee of your company when you’re an S Corp, you might technically be eligible for unemployment benefits when your salary drops or disappears unexpectedly. However, you’ll probably have a hard time qualifying as long as you keep the business operating. Many states require unemployment recipients to be actively seeking work, and owning a business could hinder that qualification.
Unemployment eligibility is in flux since temporary shifts in 2020, so keep an eye on your state’s requirements to determine whether you might qualify.
TL;DR: Get paid what you deserve for your hard work!
Running a business-of-one taxed as an S Corp can be a smart way to save some serious money on your tax bill. But, with great tax savings comes great responsibility — especially when it comes to paying yourself.
Ultimately you want to meet tax requirements while paying yourself the amount you deserve — just like you’d expect from any employer. Once you’ve got that part down, you can focus on doing what you do best: killing it in your business and getting paid what you’re worth.
Stephen has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for small businesses, entrepreneurs, independent contractors, and freelancers. He is the author of over 20 books and hundreds of articles and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Among his books are Deduct It! Lower Your Small Business Taxes, Working with Independent Contractors, and Working for Yourself: Law and Taxes for Independent Contractors, Freelancers & Consultants.