How to Pay Yourself from an S-Corp
Having a business allows you to provide a product or service on your terms with unlimited income potential. The benefits don’t stop there. A business owner has the ability to take advantage of many tax deductions that are simply not available to regular employees.
An employee works and receives a paycheck from his or her employer. The employer deducts, among other things, Social Security and Medicare from the employee’s earnings. The Social Security tax rate is 12.4% while the Medicare tax rate is 2.9%. The employer pays half and the employee pays the other half. (See this comparison of salary and taxes paid in an S-corp versus an unincorporated business.)
Things change when your business is an S-corp though. If you submit the form to become an S-corp, and the request is accepted by the IRS, you will become an employee of the corporation. This is an important fact in knowing how to pay youself in an S-corp. The corporation will then be responsible for paying both the employer’s and employee’s share of the Social Security and Medicare as well as filing all the payroll related tax forms. This not only includes tax forms to the IRS but withholding and unemployment to the State as well.
So why would anyone want to set up their business as an S-corp if all this additional responsibility comes with it? The answer….tax savings! The IRS requires that you still pay the Social Security and Medicare from some of the S-corp profits but they allow you to claim a reasonable salary that is less than what you likely would have earned as a regular employee outside of your corporation. The remaining profit of the business will flow through to your personal income tax return.
How Much Should I Pay Myself?
The question of how much to pay yourself is confusing to many new S-Corp owners. The truth is there is no hard and fast rule of how much to pay yourself. It all depends on facts and circumstances. However, the salary must be paid through payroll with Form W-2 issued and not via Form 1099.
Failing to do so can have some serious consequences. If an officer of an S-corp does not take a salary the IRS can come back and request a salary that they determine to be reasonable. Depending on the business and employment involved the unexpected demand could end up costing thousands of dollars in tax, interest and penalties.
There have been instances where S-corporations have paid salaries yet still received a letter from the IRS.
Take this situation for example:
Titus is a sales consultant. In 2019 he forms Titus SDR, Inc. which is taxed as an S-corporation. Titus SDR, Inc. earns $150,000 in its first year. The company pays him a salary of $30,000. The Bureau of Labor Statistics show that the typical annual salary for sales consultants with his experience is $80,000. The IRS subsequently sends Titus SDR, Inc. a letter demanding payroll tax on $50,000, the amount of underreported salary.
Previous tax court cases have shown that the following factors have been used to determine reasonable salary:
- 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
ADP has a payroll calculator that will give you some idea what your paycheck and tax will look like.
S-Corp Salary and QBI Deduction
The Tax Cuts and Jobs Act resulted in one of the most sweeping changes to the tax code we’ve seen in a long time. One new benefit is the Qualified Business Income (QBI) deduction which enables business owners (excluding C corporations) to take 20% off their taxable income. The deduction, which is in effect through 2025, may be limited though by the amount of salary earned.
Ideally the best time to think about reasonable compensation is as early as possible. A salary that is reasonable and known in advance allows the corporation to budget for the expenses and take any distributions into account.
If your business is not making a profit you are not required to take a salary. However, you will want to avoid taking money out of the S-corp without claiming a salary. The IRS frowns on that.
Reasonable compensation planned in advance of the effective S-Corp date allows for the amounts to be documented and substantiated. Whether you determine your salary prior to the start of the S-corp or afterwards knowing these guidelines will help keep you on the right side of an IRS audit.
Need tax help? Feel free to contact us.