Post updated June 11, 2024

Determining a reasonable shareholder salary and reasonable officer compensation is the murkiest part of running an S corporation. The biggest question we get is, “What the heck do I pay myself?”

Before we get into that, let’s discuss why a reasonable S Corp wage needs to be just above bar napkin quality and just below NASA precision. WCG CPAs & Advisors has been computing reasonable compensation for S corporations since 2007, and we believe we have it dialed in as well as anyone can.

We’ve mentioned in our website and book that the main tax benefit of an S Corp is lowering self-employment taxes. When we talk about S corporation compensation, we mean reducing Social Security and Medicare taxes (payroll taxes). When your company, or any company, pays you $10,000 in shareholder wages, 7.65% is withheld from your pay check for the employee’s portion of payroll taxes. This is broken down into 6.2% Social Security and 1.45% Medicare. Your company must also pay 7.65% for a combined percentage of 15.3%.

Therefore, a $10,000 shareholder salary costs you $1,530 in additional taxes beyond income taxes. Said differently, if you pay yourself $90,000 when $80,000 could have been a reasonable shareholder salary, you just wasted $1,530. Even a $5,000 delta equates to $765. As such, your S Corp officer compensation needs to be reasonable, sure, but it also needs to be as low as reasonableness and not-so-common sense allows.

As you go through this webpage, keep two simple things in mind:

First, the word ‘reasonable’ has an antithesis, and can be defined in the negative. In other words, while it is hard to define reasonable, we can confidently define what is unreasonable. Paying $5,000 in shareholder salaries on $100,000 in net business income (profits) for a one-person consultant S Corp is unreasonable. Most people would agree with that sentiment.

Let’s try explaining this differently. Instead of going over the reasonable limit, think of figuring out an S Corp salary as making sure it doesn’t trip the wire of being unreasonable.

To be certain, the IRS and others use the word reasonable, but they too cannot define what is precisely reasonable and what is precisely not reasonable. While the sparring of reasonable and unreasonable presents a binary situation with a winner and a loser, it is anything but binary.

Second, we highly suggest embracing the fluidity of defining a reasonable shareholder salary. If you’re the type that likes straight lines and clean garages, this will probably bug you a little. However, having the option to pitch an argument with reasonable salary calculations puts you in a favorable position.

Before we go too far with theory, statistics and related whatnot, shareholder payroll processing is an important topic. First, it tends to blow people up initially on how it all works, where does the money go, etc. Second, it is absolutely required and therefore essential to your life as an S Corp shareholder. Here are some resources to help:

Let’s jump right into some numbers first before going through reasonable S Corp salary theory developed from IRS revenue rules and tax court cases. The following table is a summary generated from IRS statistics on S corporation tax returns for the 2013 tax year. Yes, this is the most current (okay, that’s a lie… IRS released 2014 not too long ago but the data hasn’t shfited). No, we do not know why a room full of servers can’t crunch this in real-time. So here we are-

	Gross Receipts	Net Income	Officer Comp	Officer Comp %
Annual Receipts	Per Return	Per Return	Per Return	of Net Income
$25,000 to $99,999	62,552	6,672	8,871	57%
$100,000 to $249,999	168,051	22,194	22,786	51%
$250,000 to $499,999	365,476	37,732	43,158	53%
$500,000 to $999,999	720,013	58,351	67,474	54%
$1M to $2.5M	1,572,621	119,808	110,911	48%

First, some quick observations: Officer compensation is added back to net income to determine officer comp as a percentage of net income. Next, this is all industries from capital intensive manufacturing to personal services business such as attorneys, doctors, consultants, engineers, and accountants. Also, this includes S Corps who lost money, and whether they lost money and continued to pay a reasonable shareholder salary (officer compensation) is unclear. In other words, if losses were teased out, would officer compensation be reduced as a percentage of net income? We cannot quickly determine.

Here is the same data grouped by gross receipts but detailed by selected industries. First one is $100,000 to $249,999 in gross receipts-

	Gross Receipts	Net Income	Officer Comp	Officer Comp %
$100,000 to $249,999	Per Return	Per Return	Per Return	of Net Income
Finance and Insurance	160,359	34,408	23,213	40%
Real Estate	165,375	38,231	28,193	42%
Professional, Scientific	163,151	32,910	35,404	52%
Health Care	174,383	24,622	36,026	59%

And now for $250,000 to $499,999 in gross receipts-

	Gross Receipts	Net Income	Officer Comp	Officer Comp %
$250,000 to $499,999	Per Return	Per Return	Per Return	of Net Income
Finance and Insurance	366,533	77,518	62,329	45%
Real Estate	359,163	65,419	51,151	44%
Professional, Scientific	355,693	71,136	74,493	51%
Health Care	378,147	51,553	75,382	59%

There you go. Remember that officer compensation includes all fringe benefits such as self-employed health insurance and HSA contributions, and it might be influenced (increased) by those who want to maximize 401k deferrals and/or defined benefits pensions. In other words, if your S corporation earned $150,000 before shareholder salaries, and you wanted to maximize your 401k contribution, you might pay $150,000 as reasonable officer compensation which would be 100% of your business income.

Truth be told, there are some philosophical issues with calculating a reasonable S corporation salary when your labor is the only material income-producing factor for the business. Some would argue that all the S Corp’s income should then be considered shareholder wages and subjected to Social Security and Medicare taxes, since if you died the company would die (especially for specified service trades or businesses such as an attorney, accountant, or physician).

Your Butt Material Income Producing Factor

Conversely, there might be times when your business would continue without you. When WCG does business valuations, especially in divorce proceedings, we assign a value to personal and enterprise goodwill through a method called excess earnings (the recognized method in Colorado and other states, although the tides are shifting). We do this by taking a number called seller’s discretionary cash flow (SDCF) and we subtract the cash flow that is derived from tangible assets (cash, equipment, etc.). This leaves us with a theoretical number that is considered goodwill, which can be used as a proxy to determine your “value” to the business and can be leveraged into creating an S Corp salary calculator with 1s and 0s. Quantifiable stuff.

We further tease out personal goodwill and enterprise goodwill, since in some jurisdictions personal goodwill is not marital property. This might seem like an odd tangent, but a similar argument can be made for a business that does not rely on you. One great example is a financial advisor that has a small team supporting them. Typically, the fee income continues well into the future without the direct involvement of the advisor (enterprise goodwill). In this situation, an argument for a smaller salary could be warranted, since enterprise goodwill exceeds personal goodwill. Consider this:

Business Type	Owner Participation
Software developer who has gone to market	10%
Amazon retailer, a lot of drop shipments, no inventory	20%
Financial advisor with small team	30%
Doctor who is a partner in an emergency clinic	40%
Consultant, Attorney, Accountant	90%
Actor with no endorsements or couch-jumping events	100%

Of course, this is all theoretical and is open to debate, but you get the idea.

Assembled Workforce

For example, you start off as a one-person engineering firm earning $150,000 net ordinary business income (profit) after expenses and deductions but before shareholder salary. You pay yourself $65,000 and pocket $85,000 as shareholder distributions. Done.

Time moves along, and you’ve hired eight other engineers, and they are paid $90,000 each but contribute $60,000 to the bottom line of the business (using the $150,000 number above as a proxy). Even if you increase your salary to $150,000, you still have $480,000 ($60,000 x 8) available for shareholder distributions.

Developed Process

Using our previous question about the actor or on-air personality, would your answer change if this person developed a process such as podcasts, videos, merchandising, likeness licensing, etc.? Of course, it would. An actor who earns $300,000 from acting and $200,000 from other sustainable sources is much different than the surgeon who earned $500,000. As such, reasonable S corporation salaries would certainly vary.

Here’s another one to make you think. How about a financial advisor who has been in the business for 25 years? A lot of their present-day income is truly deferred earnings from multiple decades of hard work. Sounds more like an investment, doesn’t it? And as we’ve discussed, a return on an investment is more of a shareholder distribution argument than a reasonable salary argument.

We could go on and on with this.

Investor Risk

Not to go too far into the weeds, but when performing business valuations, we also consider investor value. What rate of return would an investor need to earn after paying you a reasonable salary? Of course, a lower salary to you results in a higher rate of return for the investor. We discuss investment risk and return on investment in a bit. We digress…

This web page is a condensed version of Chapter 9 Reasonable Shareholder Salary from our book, Taxpayer’s Comprehensive Guide to LLCs and S Corps. Here we will review-

• IRS Revenue Rulings and Fact Sheet 2008-25
• Tax Court Cases
• Risk Management Association (RMA), Bureau of Labor Statistics (BLS) and Salary.com
• RC Reports
• Rules of Thumb, Jumping Off Point

In 1959, IRS Revenue Ruling 59-221 held that amounts of S corporation undistributed taxable income which are required to be included in each shareholder’s gross income do not constitute net earnings from self-employment to shareholders. However, in 1974, IRS Revenue Ruling 74-44 stated that “dividends” paid to shareholders will be re-characterized as wages when such “dividends” are paid to shareholders in lieu of reasonable compensation for services performed for the S Corp. Read that again- “in lieu of” is paramount. Also, the word dividends is in quotations because in reality we call these shareholder distributions, but in 1974 they referred to them as dividends (since most S corporations were really C corporations with an S election, LLCs did not exist).

This makes sense; dividends being used to pay for services truly are wages. If Google or Amazon pays out a dividend to its shareholders, it is considered investment income. If your S corporation does the same thing to its only shareholder without an accompanying reasonable shareholder wage, then it is considered self-employment income and subject to the gaggle of taxes with that type of income.

More Things to Consider

Moving on… There are several factors to consider when coming up with a reasonable shareholder salary. The IRS through Fact Sheet 2008-25 released the following laundry list-

• Training and experience.

• Duties and responsibilities.

• Time and effort devoted to the business.

• Dividend history (IRS nomenclature, really this should be shareholder distributions- however back in the day it was C corporations who later elected to be taxed an S corporation, so dividend history still has some historical merit).

• 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.

This list actually has two applications. Since C corporations might have a tax rate that might exceed an individual tax rate (especially before Tax Cuts and Jobs Act of 2017), including being double-taxed, many small C corporations want to drive corporate income close to zero by paying high salaries. The IRS and the tax court will use this list to say your salary is too high for a C Corp. Conversely, S corporations want to increase corporate income by paying small salaries. The IRS and the tax court will talk out of the other side of their mouths by using this list to justify a higher salary. Yes, they get to have it both ways… but if you look carefully, the IRS and the tax court only focus on the too high and the too low. Just like Goldie Locks, they like things just right, and often don’t waste time trying to scrutinize a salary for the low chance of a change.

The tax court has provided some guidance over the years in several well-known cases. Here is a quick reference list-

Spicer Accounting v. United States, 918 F.2d 90 (1990)

Spicer was the only accountant working for the firm and it was owned 50-50 with his wife. He only received dividends, and claimed to donate his services to the S corporation. The court held “The Federal Insurance Contributions Act and Federal Unemployment Tax Act both define ‘wages’ as ‘all remuneration for employment… that the form of payment is immaterial… [therefore] the only relevant factor being whether payments were actually received as compensation for employment.”

Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012)

No relation to WCG or the Watsons of WCG! In this case, Watson was an accountant in a firm he owned. He drew a salary of $24,000 even though the firm grossed nearly $3 million in revenue. Watson was a Certified Public Accountant with advanced degrees. The 8th Circuit Court ruled that a reasonable person would consider the dividends paid to Watson to be “remuneration for services performed” as opposed to a return on investment. To support its position, the IRS successfully asserted that the $24,000 shareholder salary was not enough to support Watson’s lifestyle. As such, his dividends were reclassified as wages and the firm was assessed huge employment taxes plus penalties and interest.

JD & Associates, Ltd. v. United States, No. 3:04-cv-59 (District Court, North Dakota, 2006)

Dahl, an accountant and sole shareholder, paid himself a small salary. The IRS hired a valuation expert who used Risk Management Association (RMA) data to determine what other accountants were paid for similar services. The RMA data was damning enough, however what really sent this case over the edge is the Dahl paid himself less than his staff including clerical positions. While admins might be more valuable than you, in the eyes of the IRS, they cannot make more than you.

These darn accountants are out of control! Here are a couple of “wins.”

Davis v. United States, 1994 U.S. Dist. LEXIS 10725 (District Court, Colorado, 1994)

A husband and wife team owned a corporation. The husband worked elsewhere and the wife performed clerical duties (12 hours per month). Her accountant said her services were worth $8 per hour. The IRS did not challenge the value of the time commitment and therefore Davis won this case because the wife was able to prove her minimal hours.

Sean McAlary Ltd. Inc. v. Commissioner (Tax Court Summary Opinion 2013-62)

In a recent tax court case, the IRS hired a valuation expert to determine that a real estate agent should have been paid $100,755 salary out of his S Corp’s net income of $231,454. Not bad. He still took home over $130,000 in distributions, and avoided self-employment taxes (mainly Medicare) on that portion of his income. Then again, this makes sense. Real estate oftentimes sells itself thanks to the internet, and the real estate agents are merely facilitators. In other words, the actions of the real estate agent were not solely responsible for $231,454 in income.

There are two tests that tax courts have used in the past. In Label Graphics, Inc. v. Commissioner, Tax Court Memo 1998-343 which was later affirmed by the 9^th Circuit Court in 2000, the court came up with:

• The employee’s role in the company.

• A comparison of the compensation paid to similarly situated employees in similar companies.

• The character and condition of the company.

• Whether a relationship existed between the company and employee that may permit the company to disguise nondeductible corporate distributions as deductible compensation.

• Whether the compensation was paid pursuant to a (1) structured, (2) formal, and (3) consistently applied program.

 In Brewer Quality Homes, Inc. v. Commissioner, Tax Court Memo 2003-200, the court re-iterated several points from another federal court case; Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987):

• The employee’s qualifications.

• The nature, extent, and scope of the employee’s work.

• Size and complexity of the company.

• Comparison of the employee’s salary with the company’s gross and net income.

• Prevailing general economic conditions.

• Comparison of salaries with distributions to stockholders.

• Compensation for comparable positions in comparable concern.

• Salary policy of the company as to all employees.

• Amount of compensation paid to the employee in previous years.

Similarly to IRS Fact Sheet 2008-25, no single factor controls. It really is a preponderance of the evidence, as civil courts like to say. Tax court judges will go through these lists, depending on the case and the jurisdiction, and will apply the facts and circumstances to each of these factors. They essentially make a list of pluses or minuses to determine a reasonable S corporation salary.

The tax court and the IRS will attempt to support a reasonable shareholder salary based on your peers and colleagues. They will use an expert who specializes in vocational valuations, and this person might use Risk Management Association (RMA) and Bureau of Labor Statistics (BLS) data, including local and regional data, to put together reasonable compensation for an S Corp officer. How does this equate into an S Corp reasonable salary calculator? It doesn’t, but we are getting closer to quantifying it.

Our previous real estate agent benefited from this type of valuation, since his S corporation earned significantly more than the average real estate agent’s salary. But what if the opposite was true. So, instead of earning $231,454 and only paying out $100,755 in salary, what if you earned $110,000? Would you have to pay out $100,755 in salary just because you are a real estate agent in an area where other agents earn $100,755?

The answer is a true accountant or lawyer response: it depends. There are several factors that mitigate this. Perhaps you work part-time. Perhaps you simply are not as good as your peers. Maybe you focus on a different type of customer. Review the previous laundry lists, and as you go through each item, ask yourself if you could safely use that to justify a lower salary than your peers; we bet you can find many instances.

Statistics try to make a group of people seem similar so we can find patterns and draw conclusions. Some professions that seem like sure bets aren’t always what they seem. For example, some attorneys and accountants earn very different amounts. We know some attorneys who make $100,000 a year, while others make $250,000. It is very tough to jam these two square pegs into the same round hole. The same thing can be said of accountants or IT consultants. Even physicians doing the same field of work — anesthesia for instance — range between $80,000 and $400,000. It all looks like the same work, at least on paper, yet there are wildly different incomes! Do you really want the $80,000 a year doctor putting you under? What if he or she only worked one day a week, which would equate to $400,000? Yeah, we’re guessing that probably doesn’t help you feel better.

There is another lesson to be learned here. As your S Corp income increases, the reasonable S corp salary paid to the shareholders does not necessarily increase on a pro rate basis. In other words, if you peg your salary at $60,000 and that is supported with labor data, your salary does not double just because your net income in your S corporation doubles. Your salary is based on you, and the data surrounding you. Yes, the courts look at distributions and net income, and Yes, your salary would probably be increased if your net income doubles, but it is not tethered in a lock-step, $1 for $1 pattern.

For several years now, WCG CPAs & Advisors uses RCReports or Reasonable Compensation Reports, which is a consulting firm out of Denver, Colorado, for a lot of our reasonable compensation calculations. They send out a survey to you which asks a bunch of questions about qualifications, time spent on various tasks, regional data, etc. From there, and in their words, “RCReports synthesizes a proprietary blend of IRS criteria, Court Rulings, geographic data and our EXCLUSIVE database of wages to accurately assess Reasonable Compensation for S Corp, Small & Closely Held Business Owners.” Cool!

You can view a sample below, but you can also see a cool case study where a physician group went from $193,762 to $112,728. You should also check out our reasonable salary blog post analyzing this case study.

If you visit this link and read the report, RCReports does a wonderful job coming up with a number and then putting a bunch of data behind it. The report looks official and uses sources; this is a critical consideration since reasonable compensation is such a squishy thing. In other words, the IRS might challenge your reasonable S Corp salary much like a mall cop with a badge but no gun, and certainly no evidence. When you roll up with a 7-page document that has numbers, data and sources scattered about, it is super hard for the IRS to say No. For lack of better evidence, the IRS would be forced to use your evidence.

RCReports uses three approaches similar to business valuations (which we also do); cost, market, and income. The cost approach, aka the “many hats” approach, uses the theory of you doing several jobs in one. It’s like the asset approach in business valuations, where we reconstruct the business brick by brick. Similarly, for you, each piece of “hat” you wear is put together to form a reasonable compensation salary. The market approach (what similar people are paid) and income approach (what an investor would pay you to run the business) are usually used with larger businesses or with businesses that have good public data. For example, financial advisors have wonderful data from BLS.gov, Salary.com and RCReports. Otherwise, most reports that we see for our client base is the cost “many hats” approach.

Said in another way, at times you act as a janitor cleaning your office. Other times, you are a bookkeeper balancing your checkbook. Later that week, you might perform clerical duties. All of these tasks might have a lower salary than your primary task or job title, which creates a blended rate for an overall officer compensation.

Another consideration is that just because RCReports comes up with a salary, does not mean you must pay that salary. There might be circumstances which would drive down a reasonable salary, such as rapid growth, unsteady earnings, etc. Conversely, there might be circumstances, such as 401k and other external reasons, to increase your salary.

Please keep in mind, too, that reasonable compensation includes self-employed health insurance and HSA contributions. Therefore, if RCReports comes up with $80,000, but your health insurance is $10,000, then your salary should be $70,000.

WCG can do a reasonable compensation analysis for you. Yeah, we have to charge you about $400 which includes some consultation and one revision. It might seem a bit spendy, but it gives you a defensible salary and some peace of mind. Bargain!

We also encourage you to visit some of our blog posts and our book, Taxpayer’s Comprehensive Guide to LLCs and S Corps, to assist you with the reasonable salary calculations for your S corporation-

We raise the risk issue throughout our chapter on reasonable shareholder salary, but let’s touch on it some more. Please recall that shareholder distributions are financial rewards to the investor. While the detached abstract investor and the employee are the same person (you), it doesn’t change the theoretical demands of an investor. When a business valuation is calculated, discretionary cash flow is determined and then a risk premium is assigned to it. Simply stated, cash flow divided by risk (capitalization rate) equals value.

Company specific risk includes things like (just naming a few)-

• Operational History
• Volatility of Earnings
• Product or Service Concentration
• Customer Concentration
• Ability to Affect Pricing

Look at this list again, and compare it to your business. Are you relatively new? Are your earnings volatile (such as real estate)? Even 10% swings could be considered volatile. What would happen if Walmart stated in their shareholder meeting that they were predicting being off 10% next year? Heads would roll.

What about your service concentration? Think of an attorney: they pass the bar exam as a generalist, but quickly become a specialist (and forget all the other law they’ve learned). Can you take your current skill set and find a whole new gaggle of customers in a different industry or sector? Potentially, but there’s not a promise!

What about customer concentration? Are you a 1099 contractor who has one client who also happens to be your former employer? Huge risk, right? Heck, they’ve already fired you once!

What is your ability to affect pricing? Usually none. Perhaps Apple is able to do this, but probably not you, the mighty solo operator holed up in your home office.

What does all this mean? This means that any small business owner assumes a ton of risk, and that risk should demand a higher return on investment. In other words, a higher return on investment should demand higher shareholder (investor) distributions, and therefore lower shareholder salaries. It’s a lot like a teeter-totter.

The entire economic benefit of the business can only be paid out in salaries and distributions (and perhaps perquisites, which we all call “perks”). As such, if distributions are higher because of investor risk and the subsequent demand for more return on investment to meet the risk profile, then salaries must be reduced.

So you are bumping along and one day your employer decides to convert you from a W-2 employee to a 1099 contractor. Aside from this being a load-shedding sham that the IRS and most states believe to be an end-around, several large companies continue to reduce their workforce in favor of contractors.

You say, no problem, and eventually create an LLC taxed as an S corporation. Now what? Do you peg your salary to the same salary you had before? Hardly. Labor burden rates for companies can vary from 1.4 to 2.0. What does this mean? This means if a company is paying you a $100,000 salary, your actual cost to the company might be as high as $200,000. Why?

Health insurance, dental insurance, paid time off, vacation, sick pay, holiday pay, payroll taxes, workers’ compensation insurance, disability, group life insurance, office rent (smaller workforce smaller office footprint), etc. Yeah… read that again. There is a ton of overhead that gets tacked on to you as an employee. There’s no wondering why the company just converted you from W-2 to 1099. More money for them, not for you!

How does this factor in the reasonable salary conversation? Let’s say your company’s labor burden rate is 1.8 which is not far off most big, fat corporations. This would suggest that a $100,000 salary costs the company $180,000. If you are paid $100,000 as a contractor (which would be a crummy deal), then your relative salary could be $55,000. You shouldn’t get penalized if you run a leaner operation than your former employer.

What about the risk of this new arrangement? As a shareholder in an S corporation you are assuming a ton of risk: equity risk, industry risk, small business risk and company-specific risk. If we perform a business valuation where the business has a singular client, the risk of the future economic benefit (income stream) is huge.

As risk increases, we demand a higher rate of return, or increased distributions. Makes sense, right?

Mini recap!

Labor burden rate plus increased risk of singular client can suggest a lower salary than the old W-2 job. And, being converted is not a bad deal! A company car, your own 401k, business casual (PJ’s) etc.

There are plenty of professions that have great data from the Bureau of Labor Statistics (BLS), Risk Management Association (RMA) or RCReports. But let’s say your job is some odd-duck, whacky thing for which comparable data doesn’t exist. Where do we start quantitatively? At the end of the day, we need a number!

One argument that we and others have made is the concept of 1/3, 1/3, 1/3-

• 1/3 paid as shareholder salary, plus
• 1/3 retained for expenses (if necessary, otherwise flushed out at end of quarter), plus
• 1/3 distributed as return on investment (distributions)

Where the heck did we get this? A rule of thumb for service trades or businesses such as accountants, attorneys, consultants and the usual suspects is to bill three times the salary. For example, if WCG pays a CPA $80,000 per year, we hope to bill $240,000. 1/3 of this goes to salary, 1/3 goes to expenses, and 1/3 goes to Jason’s new boat in a land-locked state. Most professional firms should have net profits of about 30 to 35% (which is why CPA firms sell for about 1.1 times gross revenue… this suggests a 3-year payback period at 100% retention or about 5–6 years with the usual 60% retention… acceptable ROI).

Even if your profession is easily teased out from labor data, this 1/3 concept can still be used. The middle 1/3 above is allocated to expenses, why should you be penalized for running a leaner, meaner firm than the bloated clowns down the street?

Using the 1/3 concept is just a starting point. Since we must start somewhere, using a mathematical formula makes it easy. From there, and similar to the “plus” and “minus” approach by the IRS and Tax Court judges, we massage this salary to be reasonable for you and your business’s situation.

What does WCG CPAs & Advisors do? We take a shot of average bourbon (why waste the good stuff on salary calculations?) and then:

• If we don’t have good data from BLS.gov or other resources, and
• RCReports is not available, and
• We are not affected by other influences (max out 401k, defined benefits pension, etc.), then
• WCG starts off at around 35% to 45% depending on the profession (based on observations), and then
• Massages the number with the client using IRS guidance.

From there, we:

• Create a payroll plan with monthly Processing, and
• Create a tax plan for the household to project tax obligations (holistic tax planning), and
• Increase income tax withholdings to land on tax neutrality for April 15 (no surprises) and try to avoid estimated tax payments, and
• Re-tweak May, June and July, maybe in November

We expand on this in Chapter 10. Yay! Chapter 10? See below, and also check out the Sample Payroll Plan. Of course, a spreadsheet is only meaningful to the spreadsheet designe, so please check out the instructions too.

How does all this reasonable compensation, tax court cases, RCReports and salary data work? Confused on what to pay yourself? Don’t want to waste money unnecessarily (ok, that is a bit rhetorical)? Let’s schedule a time to chat!

Keeping your salary low is what drives the savings in an S corporation. You’ll recall that $10,000 in salary costs you about $1,530 in payroll taxes. However, through the IRS Fact Sheet and several tax court cases, the assignment of reasonable shareholder salary becomes qualitative in relation to several factors such as your role and qualifications, and the relationship to net income and distributions (just to name a few).

Labor data, such as Risk Management Association (RMA) and Bureau of Labor Statistics (BLS) including RCReports, can be hit or miss. Homogenized populations cannot definitely tell the IRS or the tax court what you should be paid. It could be a tool in your toolbox, or it could be one of the many nails in your coffin.

Also, remember self-employed health insurance and Health Savings Accounts (HSA) add to your Box 1 wages on your W-2. Let’s say your reasonable salary is $60,000, and you pay $12,000 in health insurance premiums. You would pay yourself a $48,000 salary but your W-2 Box 1 and Line 7 (Officer Compensation) on your S corporation tax return would show $60,000. However, only $48,000 is subjected to Social Security and Medicare taxes.

One of the best ways to win an argument is to never have the conversation in the first place. The IRS is focused on S corporations who don’t pay any salary at all, or who pay a ridiculously low salary. For them, it is an easy analysis. Line 7 versus Line 21 of the S Corp tax return (Form 1120S). They can also look at the K-1, Box 1 (ordinary income) and compare this to Box 16, Code D (distributions).

IRS scrutiny will only increase over time, but they also want winnable cases. The low-hanging fruit is the S Corp without any reasonable shareholder salary. Why go after someone who is paying themselves $50,000 in salary just to settle on $60,000 after negotiation? An extra $1,530 in the IRS pocket for arguably a tough audit might not be worth it to them. This is contrasted to the person who pays themselves $10,000 and it should be $60,000. There’s some cash in that IRS challenge! Pot odds, baby.

There is a calculated risk when determining reasonable S Corp wage. You can eliminate the risk by paying yourself 100% of the net business income, but then again, that completely defeats the purpose of an S Corp. You can pay yourself 0% and wait for the audit. Or, ideally, you can operate in the soft middle. In the land of obscurity. Below the radar. Whatever floats your boat! Ok, we’ll stop.

We have all this and so much more such as Section 199A deductions, entity structures, small business tax deductions, etc. in our book: