A commonly touted strategy to set your S Corp salary is to split revenue 60% as salary and 40% as distributions. Another common rule suggests splitting 50% of income as salary, 50% as distributions. Can an S Corp have one owner? Yes, 70% have one owner who decides on salary. C corporations offer owners limited liability.
Although there are no strict rules on S-Corp salary versus distributions, having large distributions and a small salary may increase IRS scrutiny. A high salary and small distributions will likely avoid scrutiny but may result in missing out on tax savings. It’s important to understand that payments are often incorrectly reported as distributions instead of payroll. To determine S Corp payroll, research the average salary for your industry.
If determining S Corp profits is difficult, a basic approach is using the 50/50 rule. Many firms advise their clients to take 50% as salary and 50% as distributions.
Deciding whether an S corp is the right choice depends on your business and financial goals. An S corp offers benefits but also follows strict rules. Consult with an accountant to determine if an S corp is a suitable structure for your business. For LLCs, property is owned by the members and is separate from the individual members who aren’t liable for LLC debts.
To form an S Corp in Hawaii, you must file Articles of Incorporation and a Statement of Information.
Reasonable S Corp salary should be consistent with similar roles in your industry. Salary is often proportional to the services provided under an employer. Taking too much in distributions can risk depleting reserves needed for emergencies. Here are steps to determine an S-Corp salary:
- Pay a reasonable salary as IRS requires. But what is considered "reasonable" can be ambiguous.
- S Corp must compensate employees and shareholders with a reasonable salary before distributing profits.
- IRS guidance suggests providing reasonable compensation to employees, with the implication that lowering salary to pay less in taxes may invite issues.
- When setting salary, consider industry standards and profitability, although profitability alone cannot define what’s reasonable.
- Primary distinction: distributions are not subject to employment taxes.
The IRS scrutinizes what they consider a reasonable salary, which is one that corresponds to the services provided to the business. Using the 50/50 or 60/40 as a guiding principle helps in this evaluation.
What constitutes a reasonable salary for an S Corp owner varies but must align with the level of services provided. The IRS will investigate if a salary does not match industry standards for similar roles.
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Market rate for type of work performed
Despite a reasonable salary, your other forms of compensation will still enjoy tax benefits. If you are actively working within your S Corp, you’ll likely require a reasonable salary.
In some cases, such as when profits or reserves are low, owners may need to adjust their salaries. In one court case, it was established that a shareholder should not earn less than less-experienced employees unless there’s a genuine inability to pay more due to the company’s financial situation.
To avoid penalties, it’s crucial for self-employed individuals and business owners to carefully calculate a fair salary. This not only optimizes earnings but also reduces the likelihood of an audit.
Consistent advice is to allocate at least half of the S corp income as salary. For example, to make the most of a solo 401(k) contribution, one would need a salary of around $200,000, which offers a larger deduction than what you might save from student loan interest reductions.
Ultimately, the IRS will scrutinize your salary in comparison to others in your industry. To avoid inviting an audit, it is wise to pay yourself in adherence to the IRS’s reasonable salary criteria.
Exceptions to this rule may occur in situations where the company’s profits or cash flow are too low to support an appropriate salary for the owners. Following a precedent set by a court case, shareholders shouldn’t be compensated less than less-experienced employees, barring insufficient profits or cash.
In closing, to avoid audit risks and potential fines, self-employed individuals and S corp owners must determine a fair salary. The 50/50 and 60/40 rules may serve as helpful starting points, but they won’t withstand IRS scrutiny without proper justification. Taking the time to establish a defensible salary now can prevent problems later on.