Hi, I’m Bette Hochberger, CPA, CGMA. If you’re an S Corp owner, understanding the intricacies of payroll is essential. A critical element to this understanding is knowing how to appropriately compensate yourself, and what the consequences are if the IRS views your compensation as an attempt to avoid payroll taxes.

How S Corp Owners Should Pay Themselves

S Corporation owners generally draw income from their businesses through a combination of salary and distributions. The salary must be processed through the company’s payroll, with appropriate payroll taxes being withheld and paid.

Determining a Reasonable Salary for S Corp Owners

The term “reasonable” can be subjective, but when it comes to S Corporation salaries, it means what other businesses would pay for similar services in comparable circumstances.

Owners can ascertain a reasonable salary by:

  1. Acquiring compensation analysis reports.
  2. Conducting research via the Bureau of Labor Statistics or other reputable sources providing salary data.

The Reasonable Salary Dilemma

The question of “how much?” is key. A reasonable salary depends on the services provided, industry standards, business profitability, the company’s size, and geographical location. It is generally advised to match or slightly surpass the going rate for similar positions in similar companies.

Payroll: A Non-negotiable for S Corp Owners

If an S Corp owner actively works in the corporation, they must be on payroll and must receive a reasonable compensation for their services. This is not just a formal requirement; it’s a legal one.

Zero Salary in the Start-Up Phase: A Risky Move?

For S Corps in the start-up phase with little to no income or running at a loss, the IRS does not insist on a minimum salary for the owner-employee. Nevertheless, this leniency is not a free pass for profitable businesses to follow suit.

The IRS’s Stance on Payroll Taxes

The IRS has focused on the issue of S Corps paying zero salary to owners, as this could signify an attempt to dodge payroll taxes. Payroll taxes are mandatory for salaries, but not for distributions, leading some S Corp owners to opt for distributions only—a significant potential loss to the tax revenue.

The Cost of Non-Compliance

Ignoring payroll obligations can lead to substantial penalties. If the IRS concludes that salary has been intentionally mischaracterized as distributions, it can impose severe fines, reclassify the distributions as salary, and demand the payment of back taxes with penalties that could double the tax bill.

Start-Up S Corps: A Special Consideration

A start-up S Corp that does not make a profit might not have to pay a reasonable salary immediately. However, this changes once there is a distribution; those must not replace reasonable compensation to evade payroll taxes.

IRS Red Flags

The IRS is always attentive against S Corps that take out tax-free distributions which are, in substance, compensation for services rendered. If the business is profitable, the owner must first be paid a reasonable salary before any tax-free distributions can be made.

S Corporation owners can enjoy payroll tax savings, but they must carefully consider and justify the salaries they pay themselves. It’s important to walk the fine line between tax efficiency and compliance to avoid the risk of hefty IRS penalties

Being informed and cautious with payroll practices is not just prudent—it’s a financial safeguard for your business’s future.

I hope you learned something new today. As always, stay safe, and I will see you next time.