How to Set a Reasonable Salary as an S Corp

Many freelancers and other small business owners find the S corporation structure attractive because of its sweet tax benefits. But taking advantage of these savings depends on your ability to follow IRS rules.

According to the federal tax agency, an S corp owner must receive “reasonable compensation” for the work they put into the business, which means you should get a regular paycheck comparable to what other employers would pay for similar services. You can then take additional profits your business earns as distributions, which come with a lower tax bill.

What the IRS doesn’t offer is a formula for how to determine a reasonable salary. Instead, you’ll need to figure out what’s right for your business. This article explains how S corp owners can determine a reasonable compensation and stay above board with the IRS. 

How S corp owners get paid

Many entrepreneurs choose the S corp status to help legally lower their tax bills. S corps are taxed as pass-through entities, which means earnings, losses, deductions, and credits from the operation all pass through to the company’s shareholders. In simple terms: the profits are passed through to the individuals who own the business and they are taxed at the individual tax rate; the business is not subject to federal income tax. This allows shareholders to avoid the double taxation that C corporations have to navigate.

Instead of the business paying a corporate tax on its earnings, the shareholders receive a salary and pay taxes on that amount on their individual returns. Then, they can take any remaining profit as distributions. You can read more about how to pay yourself as an S corp here. 

• Salary: Your salary is what you earn as an employee of the S corp. This amount is taxed as employee wages, where the employee and business split Social Security and Medicare taxes. The business will also need to pay state and federal unemployment tax on the wages.
• Distributions: If your business earns profits in excess of your reasonable compensation, you can take those profits as distributions from the business.  Social Security and Medicare taxes don’t apply to these S corp distributions, which is where the tax savings kick in. 

Some S corp owners might be tempted to take all of their earnings as distributions rather than pay themselves a salary. To prevent potential tax evasion, the IRS sets a basic guideline: You have to set a “reasonable compensation” for your work and can then take additional earnings as distributions. 

What’s considered acceptable pay varies widely in each industry and role. But generally, you’ll need to pay yourself a salary that a comparable business would pay someone to perform the same services. 

Review accepted methods of setting wages

The IRS doesn’t provide a standard formula for determining reasonable compensation. Instead, the tax agency asks that you use some type of rationale to determine your salary. Looking through accepted methods of setting wages can help when you’re defining salary for the first time: 

Market approach

Using this approach, your compensation would reflect what an employee would earn for the same position at a similar company. The market approach is a good option for owners who only have one role in the company and mostly perform managerial tasks. 

The Bureau of Labor Statistics national wage database can act as a starting point to determine fair pay. Here you’ll find average wages for more than 800 occupations on the national, state, and metro level. 

Then, to narrow down a more precise pay, you could check out salary estimation tools on websites like Glassdoor, PayScale, and ZipRecruiter. These go beyond the BLS’ general averages and account for other details, like training, years of experience, and what other businesses are paying for similar services in your area. You may find wage information in your specific town that isn’t available on the BLS database.

Cost approach

This approach, also known as the “many hats approach,” determines pay based on the multiple roles you perform for the business. For example, you might spend most of your time providing technical writing services to clients. But you probably also do some administration and marketing work to run the company. 

Each of these jobs provide a different level of pay. Using the cost approach, you’d calculate a percentage of time you spend doing work in each role, assign a wage for each, and combine the wages for one annual salary. 

You can use the BLS database and salary estimation tools to determine fair pay for each role. 

Income approach

This approach is designed for businesses that are unique or can’t find comparable wage information. Using the income approach, you’d consider the vantage point of a hypothetical investor who’s evaluating your business.

The investor might think, “I want to put money into this business. But would I get a fair return?”

If you (the owner) are taking home so much money that the investor wouldn’t get a decent return, it suggests your pay is too high. If the return looks reasonable, then your compensation is likely fair. 

Adjust for your circumstances

Using one of the above methods is a good place to start researching fair salary for your position. But you can make adjustments based on your situation. The IRS provides a list of factors that can help you determine what to pay yourself or where you have room to make changes. These factors include:

• 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.
• The use of a formula to determine compensation.

So, for example, you might decrease your salary if you work part-time, you’re new to the industry, or if you employ other workers. Once you decide on your compensation, document your rationale. You may need it if you’re ever audited by the IRS.

What about the 60/40 rule?

You may have heard about a strategy where you use percentages to divide your business’s revenue. For example, under the 60/40 rule, 60% might go toward salary and 40% toward distributions. Or, you could split the revenue down the middle, with 50% going toward distributions and the other 50% going toward salary. 

The problem? IRS guidelines specify that your compensation should reflect industry standards, your individual circumstances, and the specific job(s) you perform. Relying solely on arbitrary percentages to divide your pay would be difficult to defend in an IRS audit. So it’s not a great method to use when setting your pay. 

How often to pay yourself

You get to decide how often to pay yourself, whether it’s semi-weekly, monthly, quarterly, or even once at the end of the year. The IRS won’t require you to pay yourself unless you’re generating income. And you can take distributions at any time as well. 

You also don’t need to receive the same salary every payday. You can, for example, take a small paycheck every month and then give yourself a big year-end bonus.  

Just make sure you’re depositing payroll taxes and quarterly estimated taxes as needed. Review your salary on a regular basis as well. It may fluctuate when your revenue changes or your role at the company evolves.  

What happens if you don’t follow compliance?

If the IRS audits your tax return, it may check whether you’ve disguised compensation as distributions to yourself. The agency has the authority to reclassify some of your distributions as salary if it determines you’ve low-balled your wages. 

As a result, you’d be on the hook for back payroll taxes on the reclassified amount plus any penalties and interest the IRS imposes.