Transitioning your sole proprietorship or LLC into an S-corporation opens doors to valuable tax advantages while altering how you approach compensation. This comprehensive guide discusses the intricacies of paying yourself from an S-Corp, offering insights and essential information to navigate the nuances of reasonable salary requirements.
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S-Corp Tax Benefits Over LLC
Many small businesses initially operate as sole proprietors or limited liability companies (LLCs). However, opting for S-corporation status with the IRS can offer significant tax advantages. The main advantage for S-Corp owners is the ability to sidestep self-employment taxes on distributions beyond their S-Corp salary. This becomes especially beneficial for individuals with higher incomes where the burden of self-employment tax becomes significant.
What is Self-Employment Tax and How is it Calculated?
The self-employment tax has two components which includes the Social Security tax and the Medicare tax. Self-employed individuals are responsible for paying this entire amount since there are no payroll withholdings or employer contributions. The Social Security portion of 12.4%, for 2024, applies to the first $168,600 of earnings (up from $160,200 in 2023). The Medicare portion of the tax is 2.9% with an additional .9% when the income goes above $200,000 or $250,000 for married filing jointly (MFJ).
To calculate this tax, start by figuring out your net earnings from self-employment, which is essentially your total income minus all of your business expenses. Once you've determined the taxable portion, apply the 15.3% tax rate to the first $168,600. If your income is higher than $168,600 multiply the portion between $168,600 & $200,000 (or (250,000 if MFJ) by 2.9%. And any higher amount is multiplied by 3.8%.
Example: Let's break down the self-employment tax calculation for someone who is single with a self-employment income of $275,000.
1) Calculate Taxable Portion (net income):
Gross Income before expenses = $275,000
Business expenses = $21,037
Taxable Portion = $253,963
2) Apply Tax Rates:
The first $168,600 is taxed at 15.3%
Tax on $168,600 = $168,600 * 15.3% = $25,795.80
The portion between $168,600 and $200,000 is taxed at 2.9%
Tax on ($200,000 - $168,600) = $31,400 * 2.9% = $910.60
The amount over $200,000 is taxed at 3.8%
Tax on ($253,962.50 - $200,000) = $53,963 * 3.8% = $2,050.59
3) Total Self-Employment Tax:
Add up the individual tax amounts: $25,795.80+ $910.60 + $2,050.58 = $28,756.99
Note: The example provided above is solely an illustration of the self-employment tax and does not take into account the Federal and state income taxes that the taxpayer will also be required to pay.
Reducing the Self-Employment Tax With An S-Corp and a Reasonable Salary
An S-corporation combines the liability protection of an LLC with tax treatment similar to a C-corporation. Income passes through and is taxed on the shareholders' personal tax returns. To maintain fairness, S-Corp owner-employees need to pay themselves "reasonable compensation," subject to payroll taxes, before receiving tax-free distributions.
While the salary is subject to payroll withholdings and thus Social Security and Medicare taxes. The key benefit lies in avoiding self-employment tax on distributions, which represent your share of profits. This tax savings serves as the primary financial motivation for transitioning to an S-Corp structure.
Note: Switching to an S Corp won't bring you any self-employment tax benefits until your company turns a profit. Additionally, the S-Corp now needs to file an additional tax return so the cost of filing an additional return should be factored into the cost-benefit analysis when determining if an S-Corp structure is the right choice.
Reasonable Salary Requirement for S-Corps
As an S-Corp shareholder, you are considered an employee who must draw a "reasonable" salary for the services provided to the business. This base salary is subject to:
Federal income tax withholding
Social Security and Medicare taxes (FICA)
Federal unemployment tax (FUTA)
Any additional distributions paid beyond this reasonable salary are not subject to these payroll taxes.
Consider this scenario: If your S-Corp generates $150,000 in net business income for the year, you might decide that a reasonable salary for your services is $80,000, aligning with industry benchmarks. FICA taxes would apply only to the $80,000 salary, leaving the remaining $70,000 eligible for tax-free distributions exempt from payroll taxes.
This approach results in a self-employment tax savings of $10,710 compared to operating as a sole proprietor or LLC member, where the entire net business income is subject to self-employment tax.
The "reasonable salary" rule isn't explicitly outlined in tax law. Instead, the IRS and self-employed individuals must interpret past court cases to establish precedent, adding an additional layer of complexity to your compliance efforts! So beware - the IRS scrutinizes S-Corp owner pay to prevent abuse of this tax benefit. Unreasonably low salary levels may trigger audits, penalties, or S-Corp status revocation.
Here's a simple guideline to determine a reasonable salary: Consider what similar enterprises would pay for the same or similar services. Reflect on the typical compensation for workers in your role employed by others. Alternatively, if you've worked in a similar position before, recall your salary as an employee for guidance.
Factors to support a reasonable salary figure include your experience, qualifications, duties, hours worked, compensation at similar companies, and dividends history. The salary should align with market rates.
The 60% Rule of Thumb
Some accountants employ a quick rule of thumb when determining a reasonable salary for S Corp owners by multiplying the salary by 60% of the profit. This shortcut is a convenient way to arrive at a figure without extensive calculations.
However, it's crucial to note that this method is not foolproof and may not accurately reflect individual circumstances. Depending on the nature of the business, industry standards, and the roles of the owners, this approach might lead to salaries that are either too high or too low. Therefore, while the rule of thumb offers simplicity, it has some shortcomings.
FICA Tax Rules and Limitations
In addition to taking a reasonable salary, S-Corp owners must follow specific rules related to Social Security and Medicare taxes:
FICA taxes apply to all W-2 wage income up to annual limits
Payroll over $168,600 is exempt from Social Security tax
Each owner’s salary up to the FICA limit is subject to 15.3% combined tax
There is no limit on Medicare tax and an additional .9% is added to Medicare tax for salaries above $200K ($250k for married filing jointly).
So if your salary was set at $179,600, your FICA tax would be $25,796 (15.3% of $168,600). The $10,400 over the FICA wage base would avoid Social Security tax, but still be subject to the Medicare tax of 2.9%.
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Setting S-Corp Compensation and Distributions
The ideal S-Corp salary and distribution mix depends on your business income, number of shareholders, and FICA taxes already paid. Consider these guidelines when determining the optimal compensation structure:
Take at least a minimum reasonable salary aligned with your duties and experience based on industry data
Allocate remaining net income after full FICA taxes are met as distributions
If multiple shareholders, adjust salary and distributions according to involvement
Make distributions at year-end or quarterly based on cash flow and earnings
Maintain detailed records and document the decision methodology
The goal is to draw a justified, market-rate salary while distributing the maximum amount reasonably possible as tax-free dividends.
How to Structure Payroll and Distributions
Once you determine the optimal salary and distribution amounts, implement them systematically:
Set up payroll processing through an S-Corp-friendly provider
Establish consistent payroll dates (e.g. monthly)
Withhold income tax from salary based on your W-4
Remit employer FICA taxes and issue W-2 forms annually
Track FICA wages against the annual limit
Approve distributions via board resolutions
Report distributions on Schedule K-1 tax forms
Distribute remaining income after payroll is processed
Make equal distributions among shareholders
Pay distributions simultaneously with payroll for simplicity
Automating payroll helps streamline compliant wage payments while periodic distributions enable tax-free draws of net business profits.
Examples of S-Corp Owner Compensation
To illustrate reasonable salaries and distributions, consider these examples:
Jill is the sole shareholder of a marketing S-Corp with $200,000 of net income this year. Based on her experience as a marketing director, she determines a reasonable salary is $90,000. This is under the $168,600 FICA limit, so she pays 15.3% FICA payroll taxes on the full $90,000. She takes the remaining $110,000 as distributions exempt from these taxes giving her a tax savings of $12,905.
Bob and Susan are 50/50 shareholders of a construction S-Corp with $300,000 of 2022 income. Based on hours and duties, they each take a $75,000 salary, again under the FICA limit. This $150,000 salary uses up their full combined FICA taxes. They then take $75,000 each as distributions not subject to SE tax. Giving them a combined savings of $22,950.
These examples illustrate how properly structuring compensation as both wages and distributions minimizes total taxes for S-Corp shareholders.
Common Mistakes to Avoid
When paying yourself as an S-Corp owner, beware of these common missteps:
Taking an unreasonably low salary that triggers IRS scrutiny
Forgetting to run payroll and withhold employment taxes
Not making proportional distributions among shareholders
Paying distributions instead of wages to avoid payroll taxes
Not distributing funds when there's available cash (profit is still treated as a taxable amount whether distributed or not)
Not obtaining documentation to substantiate salaries
Neglecting to file required tax forms like W-2s and Schedule K-1s
Miscalculating FICA Social Security tax savings
Overlooking state laws regarding S-Corp compensation
Seeking guidance from United Tax can help avoid costly errors when establishing payroll and distributions.
Qualifying for and Making the S-Election
To become an S-Corp, you first must qualify then make a formal election request. Requirements include:
Being a domestic business entity
Having 100 or fewer shareholders
Having only one class of stock
Ensuring all shareholders are U.S. citizens or residents
Filing Form 2553 with a unanimous consent statement
The S-election is made by filing Form 2553 with the IRS, signed by all shareholders. The election is effective on the date filed or beginning of the tax year, whichever is later.
Putting it All Together
Deciding whether to convert to an S-corporation and how to structure owner pay as both wages and distributions requires careful analysis based on your specific tax situation. While distributing company earnings can provide self-employment tax relief, you must also pay yourself a reasonable salary aligned with your role and duties. Factoring in FICA limits, shareholder allocation, payroll processing, tax forms, and potential IRS scrutiny makes optimizing S-Corp compensation complex.
If you are considering converting or want to ensure your existing S-Corp pay structure is fully tax compliant, the tax strategists at United Tax are ready to help. Reach out to us for a comprehensive tax planning session so you can maximize savings as an S-corp owner. Our expertise allows you to use this structure to your maximum advantage.
