Determining a reasonable salary for an S Corporation shareholder is crucial for compliance and avoiding potential IRS scrutiny. When actively involved in managing an S Corporation, shareholders must ensure their compensation genuinely reflects the value of their services. Distributing profits without appropriate compensation can invite audits, potentially leading to distributions being reclassified as wages and resulting in unexpected payroll tax liabilities.
To accurately determine your reasonable salary, it’s helpful to first consider industry standards. Salary databases such as the Bureau of Labor Statistics, salary.com, or Payscale can provide useful benchmarks. Assessing your specific role, responsibilities, and daily tasks in comparison to similar positions within your industry will help you establish a fair benchmark. Additionally, your personal expertise, qualifications, professional certifications, and experience should significantly influence your compensation.
Another essential consideration is your company’s size and overall financial health, as these factors typically correlate with compensation levels. Regular consultations with a CPA or tax advisor can also offer valuable external insights, helping you justify and benchmark your compensation against industry norms clearly and convincingly.
A useful guideline, commonly applied by tax professionals, suggests splitting your total withdrawals into approximately 50% salary and up to 50% as distributions. For example, if your total annual withdrawals are around $80,000, setting a minimum of $40,000 as salary with the remainder as distributions can strike a balanced approach that meets IRS standards.
However, sometimes profitability may not support even this standard. In such cases, prioritizing salary payments, even minimal ones, before taking distributions is critical. If funds are limited, significantly reducing or temporarily eliminating distributions is wise until financial conditions improve.
Detailed documentation of your financial situation, such as financial statements, cash flow analyses, and market assessments, is essential to justify temporary salary adjustments. It might become necessary to reduce or defer salary payments during difficult periods, but these decisions should be clearly documented to demonstrate financial necessity and compliance efforts.
Developing a proactive financial improvement plan outlining clear strategies to enhance profitability will demonstrate good faith in addressing salary issues. Regular, ongoing discussions with your CPA or financial advisor will ensure you’re appropriately responding to changing circumstances and maintaining compliance as your company recovers financially.
Ultimately, consistently assessing and documenting your salary decisions and working closely with professional advisors will protect both you and your business, ensuring long-term compliance and financial health.
If you need help determining what your reasonable salary should be, reach out to us at High Impact CPA. You can book a call here:
