What is a reasonable salary? Well, the IRS can’t tell you. In fact, there are no specific guidelines in the tax code for what is reasonable compensation to be paid to the owner-employee of a Sub-S entity. According to one source I checked, most of the court cases on salary issues involve a salary that is too high because the owners of a C-corporation (not an S-corporation) tried to take too much money out of the company to avoid the double taxation (these would be cases prior to the Tax Reform Act of 2017-18 when the C-corporation rate was dropped to 21%). Many of the cases I looked at show that the IRS has a slam-dunk chance of winning when the owner of a Sub-S entity does not pay themselves any salary. The IRS track record of winning those cases is almost 100%. You do not want to be next.
When determining a proper reasonable salary, the following factors should be considered:
- the training and experience necessary to do the job;
- the duties and responsibilities of the job;
- the time involved and the amount of effort devoted to the business;
- the dividend payment or profit distribution history of the company;
- the salary being paid to other non-shareholder/non-owner employees;
- payments to other individuals doing comparable work in similar businesses;
- payments by other comparable businesses for similar services;
- what, if any, written compensation agreements exist, and
- the type of formula used by the company to determine compensation.
One of the most important steps an owner of a Sub-S business can do when paying himself/herself a reasonable salary is to gather facts and information to support the salary they have chosen. In most instances, that salary will be as low as they deem practical to live on.
There is a key fact that comes up repeatedly when considering a reasonable salary for an owner-employee. What would that company have to pay a third-party employee to do the same or similar job? You can find that information in a trade survey, from Headhunters, in job ads, etc. You should keep this information on file showing the notes and math calculations you made on the pages as you studied them. That would also be good proof that you had this evidence at the time you made your salary decision.
Many Sub-S owner-employees pay themselves monthly with both a reasonable salary and a profit distribution. When times might be tough, as in the past few months, does a business owner just take their salary and not take a profit distribution? That would be good evidence that it is a reasonable salary. Then, when the company once again has increased cash from increased business activity, the owner-employee can again be paid both a reasonable salary and profit distribution. That blip of 1-2 months showing just a salary paid and no profit distribution would be extremely powerful evidence to show that it was “reasonable”.