As we have discussed before, choosing the right business entity is one of the most important decisions you will make as an entrepreneur. It will affect your legal liability, your tax liability, which tax forms you file and what other requirements you have to fulfill throughout the year.
While I generally stay away from broad recommendations, especially with something as serious as your business entity, I strongly believe that most profitable small businesses should operate as an LLC. taxed as an S-Corporation. This entity has the ability to save the owners thousands of dollars in taxes while still offering maximum liability protection.
If all those tax savings are starting to sound pretty good, don’t make the move quite yet. There are some requirements the IRS puts in place in order to use the distinction of LLC. taxed as an S Corp. You will have to file different tax forms, pay for various employment insurances and do more record keeping.
But perhaps the biggest requirement of becoming an S-Corp is the need to pay a reasonable salary to any owners who also work in the company. Since most of you are the sole owners in your company, this means you must pay yourself a reasonable salary every year in order to maintain your S-Corporation status.
The reason for the salary requirement is simple; unlike LLC.’s and sole proprietorships, the profits from an S-Corp are not subject to self-employment tax. In order to offset at least a portion of those lost taxes, the IRS requires you to pay yourself a salary, which is then subject to the same payroll taxes that make up self-employment taxes.
What is reasonable
Unfortunately, as with most things IRS related, what exactly constitutes a “reasonable” salary isn’t entirely clear. What is clear is that if the IRS determines your salary is not reasonable, they will hit you with some pretty heavy fines.
Just to summarize that last paragraph, the IRS isn’t quite sure what a reasonable salary is, but if they determine you aren’t meeting it, they will fine the crap out of you. Seems pretty fair, right?
Fortunately, the IRS does give us a few guidelines they use to determine a reasonable salary. Here are several factors you will want to use to determine what a reasonable salary is for you:
1. Duties performed by the employee- What type of work do you do within the business. Is it work that others are paid highly for, or is lower wage type work?
2. The volume of business handled- How much work are you actually doing? The more work you do the higher they expect your salary to be.
3. The amount of time devoted to the business- Some people spend 60 hours a week working in their business, some people spend ten. The more time you spend the higher the IRS will determine a reasonable salary to be.
4. The cost of living for your location- A reasonable salary in San Diego, California is probably a bit higher than a reasonable salary in Willard, Ohio.
5. The ability and achievements of the person performing the work- If you are nationally recognized figure in your industry, your salary should be a bit higher than a brand new person in your industry.
6. The overall profitability of the business- A business that generates $150,000 in profits has a higher expected salary than one that generates $30,000 in profits.
7. Your payment history- If you paid yourself a $100,000 salary last year and are only paying yourself $20,000 this year, you better have a damn good reason for it. Unless there are unexpected drops in profits or other mitigating circumstances, the IRS expects your salary to stay consistent from year to year.
If you are just getting started in your business and you really don’t have the answers to most of those questions yet, I think a conservative way to determine your reasonable salary is to pay yourself 50 percent of your profits. Having discussed the issue with several other CPA’s, most seem to be in agreement that the 50 percent threshold will most likely be enough to keep you out of the crosshairs of the IRS.
Use Common Sense
Even with all these factors that come into determining a reasonable salary, the best way to figure out the amount for you is to use some good old common sense. If you know the going rate for a person doing similar work in your area is $50,000, don’t pay yourself $15,000. Chances are you have a good idea of what a reasonable salary is in your industry, put that knowledge to use and you will be just fine.
An LLC. taxed as an S-Corp is an awesome way to save significant tax dollars and keep you and your family protected. But if you don’t pay yourself a reasonable salary, you will be coughing up all those savings and more in penalties and interest.