The answer most shareholders want to hear: whatever you want!
The realistic answer: It depends.
As an S-Corp shareholder, you are privy to additional savings when it comes to tax time. But to stay off the radar of the IRS, you have to be careful about exactly how and how much you pay yourself.
A “reasonable salary” is a vague term – it’d be much easier if the IRS just told you what to pay yourself to be deemed reasonable, but it’s simply not that simple. According to the IRS, a reasonable salary is a paycheck comparable to what other employers would pay for similar services. If there’s additional profit in the business, you can take those as distributions, which come with a lower tax bill.
When we assist clients with determining a reasonable salary, we start by asking: What do you do for this business? For business owners, this can be difficult because business owners wear many hats – you may be the CEO, the administrative assistant, the marketing manager and the janitor. That’s what makes reasonability so unique. Think through a normal week – determine how many hours you spend in each role.
Once we’ve nailed down the roles and responsibilities of the business owner, the next question is: would it cost you to hire someone to replace you? This is often a blended rate, because the pay rate for the janitor is likely different from the CEO’s pay rate. You can check out similar job postings in your area to determine the going rate for the roles you play in the business. If we know the amount of time you generally spend on each category of tasks, we can use that to come up with a blended rate.
Lastly, we ask: How is your business currently performing? If you spend 40+ hours as a CEO and other CEOs in your industry and geographic area are paid $400k per year, but your business only nets $100k, then a $400k salary is not reasonable. So after looking at what the industry considers reasonable, we have to tailor that information for your current business performance.
The best thing to do to support your determined reasonable compensation amount is to document it. As a previous auditor, I believe heavily in documentation. Write down what your thought process was when determining the reasonable compensation amount, and save the links to the job posts you researched when determining it. This will give you a baseline as you evaluate the reasonableness of your compensation in the future as the business changes. In the unfortunate event of an IRS audit where they may want to reclassify wages based on their determination of reasonableness, you can use this documentation to support your thought process in an effort to mitigate or eliminate any audit adjustments.
I know this can seem a bit nerve wracking and overwhelming. Let us help and consult with you to determine your reasonable salary and support you in documenting it properly.