Mid-Year Check for S Corp Owners: Are You Paying Yourself a Reasonable Salary?
· RKube Services
S corp owners who work in the business need to take a reasonable salary before distributions. Here's how to think about it, and why May is a good time to check.
Every spring we see a version of the same return. An S corp owner works full time in the business, the company earned a solid profit, and the owner's W-2 shows a salary of zero, or something like $12,000. Everything else came out as distributions.
It's usually not an attempt to cheat. Often someone told them "S corps save on payroll taxes" and nobody explained the other half of that sentence. The other half is that the IRS expects shareholder-employees to be paid a reasonable salary first.
Salary vs. Distributions
If you own an S corporation and work in it, money can reach you in two main ways:
- Salary (W-2 wages): run through payroll, with income tax withheld and Social Security and Medicare taxes paid on both the employee and employer side.
- Distributions: a share of profits paid out to owners. The profit is still taxed as income on your personal return through the K-1, but distributions aren't subject to payroll taxes.
That payroll tax difference is exactly why the IRS pays attention. If an owner-employee takes little or no salary and large distributions, the IRS can recharacterize some of those distributions as wages, and then assess the payroll taxes, penalties, and interest that should have been paid.
What Does "Reasonable" Mean?
There's no fixed formula or percentage in the tax code, and anyone who gives you a hard rule like "always pay yourself 60%" is oversimplifying. The basic question is what you'd have to pay someone else to do the work you do. Factors the IRS and courts have considered include:
- Your training and experience
- Your duties and responsibilities
- Time and effort you devote to the business
- What comparable businesses pay for similar services
- What the company pays non-owner employees
- Timing and manner of bonuses, and the company's distribution history
In practice, people start with a role-based question. If you're the lead engineer and CEO of a ten-person firm, what would that job cost on the open market in your area? If you're a part-time owner who mostly reviews reports, the answer is very different. It also helps to document how you arrived at the number, whether that's salary survey data, job postings, or industry compensation reports.
Source: IRS: S Corporation Compensation and Medical Insurance Issues and IRS Fact Sheet FS-2008-25, Wage Compensation for S Corporation Officers
A Worked Example
Say your S corp expects $150,000 of profit this year before paying you. Compare two approaches:
- Option A: $40,000 salary, the rest as distributions
- Option B: $75,000 salary, the rest as distributions
Social Security and Medicare combined are 15.3% of wages (7.65% withheld from you, 7.65% paid by the company), as long as wages are under the Social Security wage base, which both of these are.
- Option A payroll taxes: $40,000 × 15.3% = $6,120
- Option B payroll taxes: $75,000 × 15.3% = $11,475
So Option A costs about $5,355 less in payroll tax this year. That's the appeal. But if the work you do is worth $75,000 or more and an examiner agrees, the lower salary can be reclassified, and the savings turn into back taxes plus penalties and interest. The gap is also a bit smaller than it looks, because the employer half of payroll tax is a deductible business expense.
This is simplified. It leaves out state unemployment tax, federal unemployment tax, and income tax effects, which vary. The point is to see the trade-off, not to pick a number.
Why Check in May
You're almost halfway through the year and your first-quarter Form 941 has already been filed. If your salary is too low, fixing it now means spreading the increase across the remaining payrolls. Wait until December and you're stuck running one large catch-up payroll, which is harder on cash and on withholding. It's also a natural time to line up your salary with your quarterly estimates, since the June 15 payment is coming up.
How RKube Helps
- Review your year-to-date profit and current owner salary side by side
- Help you gather comparable-pay data and document how your salary was set
- Adjust payroll for the rest of the year so changes are gradual, not a year-end scramble
- Coordinate salary, distributions, and quarterly estimates so they work together
If you'd like a second set of eyes on your S corp payroll, call us at (984) 234-7030 or start with a free 30-day bookkeeping trial: https://rkubeservices.com/campaign
Final Thoughts
The S corp structure can make sense for many owners, but the payroll tax benefit depends on paying yourself a salary you can defend. This is general information, and the right number depends on your role and your market, so talk with a tax professional about your situation. The best time to fix a low salary is mid-year, not after the IRS asks.
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