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Can I pay myself what I believe is a fair salary for what I do for my company?
When S-Corp owners select a salary, the IRS looks for several factors to ensure that the compensation is "reasonable." The key concern for the IRS is that owners are not underpaying themselves in salary to avoid payroll taxes while taking larger distributions, which are not subject to the same taxes.
Here are the main considerations the IRS looks for:
1. Reasonable Compensation
The IRS requires S-Corp owners to take a reasonable salary for the work they perform. This is determined based on what would be paid for similar services by similar businesses under similar circumstances.
2. Factors Determining Reasonable Salary
The IRS considers various factors to determine if the salary is reasonable, including:
Training and Experience: The owner's background, skills, and qualifications.
Duties and Responsibilities: The nature and extent of the work performed by the owner.
Time and Effort Devoted: Hours worked and the intensity of the owner's involvement in the business.
Comparable Salaries: What similar businesses pay for similar roles.
Location: Geographic location and cost of living.
Company Size and Financial Condition: Revenue, profitability, and financial health of the business.
Salary History: Historical salaries of the owner and similar employees within the company.
3. Common IRS Indicators
The IRS may flag an S-Corp owner’s salary for:
Low or No Salary: The owner takes a disproportionately low salary compared to the distributions.
Discrepancies in Compensation: Significant discrepancies between what the owner is paid and industry norms.
High Distributions with Low Salaries: High distributions to shareholders but low reported salaries.
4. Supporting Documentation
Owners should maintain thorough records to justify their salary decisions, such as:
Job Descriptions: Detailed job descriptions for roles and responsibilities.
Salary Surveys and Studies: Industry salary surveys or studies showing comparable salaries.
Business Performance Records: Financial statements and business performance metrics.
Time Logs: Documentation of hours worked and tasks performed by the owner.
5. Legal Precedents and IRS Guidance
Owners can refer to IRS rulings and court cases that provide guidance on what constitutes reasonable compensation, as follows:
IRS Fact Sheet FS-2008-25: Provides guidelines on reasonable compensation.
Court Cases: Examples include Watson v. Commissioner and JD & Associates, Ltd. v. United States, which outline considerations for reasonable salaries.
Example Scenario
Suppose an S-Corp owner works full-time in their business and has comparable businesses in their area paying $90,000 per year for similar roles. The owner’s company generates $300,000 in revenue annually. A reasonable salary in this context might be around $90,000, reflecting industry norms, while the remaining profits can be taken as distributions.
Conclusion
To avoid IRS scrutiny, S-Corp owners should:
1. Pay themselves a salary comparable to what similar positions earn in their industry and region.
2. Document the rationale for their salary with supporting evidence.
3. Balance their salary and distributions to reflect reasonable compensation for their work.
By adhering to these guidelines, S-Corp owners can ensure their salary choices align with IRS expectations and minimize the risk of audits and penalties.
