Understanding IRS Allowable Salary for S Corporation Owners
As a Certified Public Accountant (CPA) working with numerous S Corporation owners, a common question I encounter is: "How do I determine an appropriate salary for myself that will be acceptable to the IRS?" Navigating the landscape of reasonable compensation can be tricky, but a solid grasp of the fundamental concepts and the facts and circumstances involved can set you on the right path.
Why is Reasonable Compensation Important for S Corporation Owners?
Before diving into the details, let's briefly discuss the significance of the topic. S Corporation owners often take two forms of payments from their business: salary and distributions. Only the salary portion is subject to payroll taxes (like Social Security and Medicare taxes), while the distributions are not. This sets up a potential incentive for owners to minimize their salary and take more in distributions, thereby reducing their payroll tax liability. However, the IRS requires S Corporation owners who provide services to the corporation to pay themselves a "reasonable" salary.
Determining Reasonable Compensation
The term "reasonable" is subjective, and unfortunately, the IRS doesn't provide a clear-cut formula. Instead, they review each case based on relevant facts and circumstances. Here are some pivotal factors the IRS considers:
Roles and Responsibilities: The duties and responsibilities associated with your position play a crucial role in determining your compensation. If you're wearing multiple hats—acting as a manager, marketer, and service provider, for instance—this can justify a higher salary.
Experience and Qualifications: Your education, experience, training, and professional achievements will factor into what constitutes a reasonable salary. For instance, a seasoned professional with a proven track record may warrant higher compensation than someone just starting out.
Time and Effort Devoted: If you're working full-time for the S Corporation or even putting in overtime, you'd naturally expect a salary that reflects this commitment.
Dividend History: If your S Corporation is regularly providing distributions in addition to salary, the IRS may view an excessively low salary with suspicion.
Payment to Non-Shareholder Employees: If non-owner employees in your S Corporation with similar responsibilities are receiving a higher salary than the owner, this could raise red flags.
Comparative Salaries in Your Industry: It's crucial to understand the industry standards. If other professionals in your sector, with similar roles and in similar geographies, are earning significantly more, your salary might be deemed unreasonably low.
Economic Conditions: The overall economic condition, especially localized to your business area or industry, can also be a determining factor. In a downturn, it might be justifiable to have a reduced salary, but it should be in line with the overall economic landscape.
Compensation as a Percentage of Corporate Sales or Profits: While there's no fixed ratio, if an owner's salary is only a tiny fraction of substantial corporate sales or profits, the IRS might question its reasonableness.
Documenting Reasonable Compensation: The Role of Corporate Minutes
Ensuring that your salary as an S Corporation owner is not only reasonable but also well-documented is vital for compliance and defense in the event of an IRS inquiry. An essential tool in this documentation process is the use of corporate minutes.
What are Corporate Minutes?
Corporate minutes are written records that capture the discussions and decisions made during corporate meetings. For S Corporations, they serve as evidence that the management and shareholders have met and deliberated on various business matters, including compensation.
Why Are Corporate Minutes Vital in Documenting Reasonable Compensation?
Evidence of Deliberation: By recording discussions about compensation in the corporate minutes, you provide evidence that the company's leadership has thoughtfully considered and agreed upon the salary in question.
Contextual Understanding: Corporate minutes can provide context. For example, if the company decided to pay a higher salary due to increased responsibilities or an expansion in the owner's role, this can be clearly stated and understood later.
Benchmarking and Comparisons: The minutes can document any references made to industry standards, surveys, or other benchmarking tools the company used to determine the owner's salary.
Annual Reviews: As businesses evolve, so might the roles and responsibilities of the S Corporation owner. Documenting annual reviews of compensation in the minutes showcases a consistent effort to ensure that the compensation remains reasonable.
Best Practices for Documenting Compensation in Corporate Minutes
Be Detailed: Rather than a vague statement like "The board discussed the owner's salary," provide more detail. For instance, "The board reviewed industry compensation surveys and discussed the expanded managerial role of the owner before settling on the proposed salary."
Reference External Data: If you've used salary surveys, industry benchmarks or consulted with compensation experts, mention these in the minutes.
Document Unanimity or Dissent: It can be beneficial to note if the decision on compensation was unanimous or if there were dissenting opinions. If someone disagreed, briefly outline the reasons for the dissent.
Update Regularly: Any time there's a change in the owner's compensation, or at least annually, the issue should be revisited in a formal meeting and documented in the corporate minutes.
Store Safely: Ensure that corporate minutes are stored securely, whether in physical form in a safe location or digitally with backup and encryption.
Final Thoughts
Determining a reasonable salary for S Corporation owners can be a complex endeavor. It's a balancing act between ensuring you're compensated fairly for your efforts and maintaining compliance with IRS expectations to avoid penalties.
Remember, while it might be tempting to reduce your salary to minimize payroll taxes, the risks associated with drawing an unreasonably low salary—such as increased IRS scrutiny and potential penalties—can far outweigh the short-term benefits.
In conclusion, while the process of determining a reasonable salary involves various factors and considerations, documenting the decision-making process in corporate minutes offers a layer of protection. It demonstrates due diligence and transparency in the eyes of the IRS, reducing potential risks associated with salary disputes.
Always consult with your CPA or tax professional when setting your compensation, and consider conducting a regular review to ensure ongoing compliance with IRS guidelines.