S-Corp Salary 60/40 Rule: Reasonable Compensation Guide [+ IRS Pitfalls]

You probably know by now that S-Corps are one of the best entity structures for small business owners. But when it comes to payroll, the owner has decisions to make. Specifically, they may consider the S-Corp salary 60/40 rule.

In this post, we will discuss how the IRS reasonable compensation rules works and try to give business owners a framework to decide on owner compensation. Let’s get started!

Some Background

As a bit of background, S-Corporations are considered pass-through entities. This means that the profits and losses of the business “pass-through” to the shareholders, who report them on their personal tax returns. One advantage of the S-Corporation structure is that shareholders can avoid paying self-employment taxes on a portion of the business income.

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However, the IRS requires that S-Corporation shareholders who are also company employees receive “reasonable compensation” for their services. If the shareholder-employee is not paid a reasonable salary, they may be tempted to classify too much of their income as distributions, resulting in a lower tax liability.

What is the S-corp salary 60/40 rule?

The “S-Corp Salary 60/40 Rule” is a guideline that S-Corporation owners often use to determine a reasonable salary for themselves.

The 60/40 rule is a common guideline that some S-Corporation owners use to determine a reasonable salary. The rule suggests that the owner should pay themselves a salary equal to 60% of their overall compensation, with the remaining 40% classified as distributions. So, for example, if an owner earns $100,000 in total compensation, they would pay themselves a salary of $60,000 and classify the remaining $40,000 as a distribution.

It’s important to note that the 60/40 rule is not an official IRS regulation but rather a commonly used guideline. The IRS evaluates each S-Corporation’s compensation practices on a case-by-case basis, considering factors such as the nature of the business, the owner’s role in the business, and industry norms.

What does the IRS say about the S-Corp reasonable compensation rules?

First of all, the 60/40 rule has not been codified by the IRS, nor does the IRS say that it is an acceptable way to determine reasonable compensation. It has just been a rule of thumb that CPAs and tax preparers have used for decades.

The IRS requires that S-corporation owners who provide services to the company must receive reasonable compensation for their work. The agency has issued guidance on what constitutes reasonable compensation, but it does not provide a specific formula for determining the amount.

According to the IRS, reasonable compensation is the amount that would ordinarily be paid for similar services by a similar company in similar circumstances. The agency considers factors such as the employee’s qualifications and experience, the nature of the services provided, and the company’s size and profitability in determining what constitutes reasonable compensation.

It’s important to note that failure to pay reasonable compensation can result in tax penalties and potentially jeopardize the company’s status as an S-corporation. It’s recommended that S-corporation owners consult with a tax professional to ensure they are in compliance with the reasonable compensation rules.

How should a business owner determine reasonable compensation for an S-Corp?

Determining reasonable compensation for an S-corporation owner can be a difficult process, but there are several factors that business owners can consider to help determine what constitutes reasonable compensation:

  1. Industry standards: Business owners can look at industry standards for similar jobs in similar companies to get an idea of the market rate for the services they provide.
  2. Job responsibilities: Business owners should consider the scope of their job responsibilities, including the level of expertise required, the amount of time spent on the job, and any specialized skills or certifications needed. If you are a physician, then you should have a higher wage.
  3. Company profitability: Business owners should look at their company’s financial performance to determine what they can afford to pay themselves. It’s essential to strike a balance between paying yourself a reasonable salary and ensuring that the company has enough funds to cover its expenses.
  4. Geographic location: Business owners should consider the cost of living in their geographic location when determining reasonable compensation. Salaries can vary widely depending on the location.
  5. Comparable salaries: Business owners should also consider what they would pay an outside employee to perform the same job duties.

It’s important to remember that reasonable compensation must be based on the services the business owner provides to the S-corporation rather than any investments they make in the company. The S-Corp salary 60/40 rule can be used as a guide but it is not authoritative. Business owners should consult with a tax professional to ensure their compensation is reasonable and complies with IRS guidelines.

S-Corp AdvantagesS-Corp Disadvantages
Lower IRS Audit ProfileHigher Planning Costs
Employment Tax ReductionMore Tax Complexity
Separate StructureOwner Compensation Required
Flow-Through TaxationFiling Form 1120-S

Final thoughts

In summary, reasonable compensation is the amount of pay that an S-corporation owner must receive for the services they provide to the company. The IRS requires that S-corporation owners receive reasonable compensation to ensure that they are not using the S-corporation structure to avoid paying employment taxes on their earnings. Reasonable compensation is determined by various factors such as industry standards, job responsibilities, company profitability, geographic location, and comparable salaries.

It’s important for business owners to understand the rules surrounding reasonable compensation to avoid potential tax penalties and legal issues. Failure to pay reasonable compensation can result in the reclassification of earnings as dividends, which are subject to higher tax rates.

Moreover, the IRS may scrutinize S-corporations that pay owners unreasonably low salaries as a means of avoiding payroll taxes. Consulting with a tax professional can help business owners determine the appropriate level of compensation and ensure compliance with IRS regulations.

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