Why the salary matters at all
An S-corp owner who works in the business is paid in two ways. The salary is wages, with Social Security and Medicare taken out and matched by the business. The rest of the profit can come out as distributions, which carry no payroll tax.
The saving from the election is the payroll tax not paid on the distributions. The lower the salary, the bigger it looks, which is exactly why the IRS cares what the salary is.
What the IRS actually says
Neither the tax code nor the regulations give a number. The IRS position is that an officer who performs more than minor services is an employee, and that compensation for those services should not be dressed up as distributions, loans or payments of personal expenses.
Courts decide on the facts of each case. The factors they and the IRS look at include:
- Your training and experience
- Your duties and responsibilities
- The time and effort you devote to the business
- What comparable businesses pay for comparable work
- How the salary compares with the distributions
- What the business can actually afford
A way to arrive at a figure
Start with the market: what would it cost to hire someone to do your job? Wage surveys by occupation and region, such as the Bureau of Labor Statistics occupational data, are the usual reference. If you do several jobs, price the time you spend on each.
Adjust for hours. Someone who works on the business ten hours a week is not owed a full-time salary; someone who works sixty probably is.
Then check it against the business. A salary larger than the profit is not required, and in a year when the business makes little and distributes nothing, a small salary is easier to defend.
Write down how you got there. A short note with the sources you used, kept with the year’s records, is most of what a defence looks like.
What happens when it is too low
The IRS can reclassify distributions as wages and charge the payroll tax that should have been paid on them, with interest and penalties.
The case usually cited is Watson v. United States. An accountant paid himself $24,000 a year while taking well over $100,000 in distributions; the court found a salary of about $91,000 reasonable and the difference was taxed as wages. The figure was specific to him. The pattern is the lesson.
Rules of thumb such as a fixed split between salary and distributions have no standing. They are a starting point at best.
With two or more owners
Each owner who works in the business needs their own reasonable salary, based on their own work. Two owners who do different jobs, or work different hours, can and often should be paid different salaries.
Distributions are the opposite. They must follow ownership exactly: two owners at 50% each take equal distributions, whatever their salaries are. Uneven distributions can be treated as a second class of stock, which an S-corp is not allowed to have, so it is worth evening them out before the year ends.