Understanding S-Corporations and the Importance of a Reasonable Salary
When small business owners in the United States look for tax advantages, many choose to structure their businesses as S-Corporations (S-Corps).
But what exactly is an S-Corp, and why is it crucial to pay yourself a reasonable salary if you're the owner? Let's break it down. What is an S-Corp?
An S-Corporation is a special type of corporation that allows businesses to pass corporate income, losses, deductions, and credits to their shareholders for federal tax purposes. Essentially, instead of the business paying taxes at the corporate level, its profits and losses are passed through to the owners, who then report them on their personal tax returns.
The S-Corp structure is attractive to small business owners because it can offer significant tax savings. Unlike C-Corporations, which face "double taxation" (once at the corporate level and again at the individual level when dividends are paid), S-Corps avoid this by having all income taxed only once, at the shareholder level.
The Importance of a Reasonable Salary
If you own an S-Corp and work in the business, the IRS requires you to pay yourself a reasonable salary for the work you do. But why is this so important?
Avoid IRS Scrutiny: One of the most significant advantages of an S-Corp is that the owners can save on self-employment taxes by distributing some profits as distributions instead of salary. Distributions are not subject to Social Security and Medicare taxes, but the IRS is very clear: business owners cannot take all profits as distributions to avoid taxes. By paying yourself a reasonable salary, you help ensure compliance with IRS rules and avoid penalties.
Fair Share of Taxes: A reasonable salary ensures that you are paying your fair share of employment taxes, specifically Social Security and Medicare. If the IRS determines that your salary is unreasonably low compared to your role in the company, they may reclassify your distributions as salary and apply taxes and penalties retroactively.
Benchmarking Your Salary: The IRS doesn't provide strict guidelines on what qualifies as a reasonable salary, but they consider factors such as:
Your experience and skill level
The type of work you perform
Salaries of similar roles in your industry To protect yourself, it's wise to research what someone in your position would be paid in a similar business or industry.
Balance Between Salary and Distributions: Paying a reasonable salary also helps you maintain a healthy balance between the taxes you pay and the distributions you receive. If you take too little salary and too many distributions, you may invite IRS scrutiny. On the other hand, if your salary is too high, you may end up overpaying in payroll taxes.
Final Thoughts
Choosing to become an S-Corp can provide business owners with notable tax advantages, but it comes with responsibilities. Paying yourself a reasonable salary is essential not only to stay compliant with IRS regulations but also to maintain a balanced approach to taxes. By striking the right balance between salary and distributions, you can maximize your tax savings while avoiding unnecessary legal headaches.
The DBC Team can support you at all stages of this process - from deciding to become an S-Corp to determining the right balance between salary & distributions. Reach out to our team so we can understand your business & personal goals!