Determine a Reasonable Salary
The first step is to determine a reasonable salary for the owner-employee. This step is somewhat subjective and will depend on the risk tolerance of the owner-employee. The goal is to determine the amount that the owner-employee can comfortable defend if the tax return is audited.
The IRS lists the following nine factors for determining whether an owner-employee’s compensation is “reasonable:”
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
This standard provides general guidance, but it does not yield any definite range for a given owner-employee’s salary. If possible, the best approach (short of hiring a compensation consultant) is to gather comparable compensation information from third-party resources—for example, the Bureau of Labor Statistics, Indeed.com, and Salary.com—and average them to determine a reasonable salary. These resources provide objective, third-party indications of a reasonable salary.
For owner-employees that play a key role in the business, it may be difficult to match their job description to a comparable salaried position. In this situation, the best practice is to divide the owner-employee’s responsibilities into percentages that match the third-party data sources and use those percentages to calculate the owner-employee’s salary.
For example, if the owner-employee spends 30 percent of her time in marketing, and the data indicates that the average salary for a marketing coordinator is $50,000, then 30 percent of the owner-employee’s salary would be paid at a rate of $50,000 ($15,000). The remaining 70 percent would be paid at different rates, depending on the nature of the work that the owner-employee performs.
As with most issues involving “reasonableness,” adequate documentation can help support the reasonableness of compensation if IRS audits the business. It is best to create a formal employment agreement between the owner-employee and the corporation. The employment agreement provides documentation of the basis for determining the owner-employee’s salary and the contractual obligations of the business to pay that salary.
Calculate the Tax Savings
Calculate the tax savings resulting from electing to be taxed as an S corporation. If a reasonable salary is below the social security wage base, the shareholder-employee can save 15.3 percent of the difference between the salary and the social security wage base. If a reasonable salary is above the social security wage base, the owner will be able to save between 2.9 and 3.8 percent of overall compensation, depending on whether the owner-employee would otherwise be subject to the Medicare surtax. Either way, quantifying the amount of the potential tax savings helps the owner-employee make an informed decision.
Determine the Cost of Being Taxed as an S Corporation
The cost will usually include the tax savings resulting any retirement contributions that would be limited by the lower salary, as well as any additional administrative cost for filing additional tax returns and paying for payroll service.
Compare the Tax Savings to the Cost
Compare the tax savings (Step 2) to the cost (Step 3) to decide whether the business should be taxed as an S corporation. If the savings is significantly higher than the cost, then make the election to be taxed as an S corporation. If it is close, or if there is no clear savings, the best choice is to remain under the default classification.