If you operate as an S corporation, you have some different compliance hoops to jump through then if you were a sole proprietor or had created a partnership structure.
One of those “hoops” is making sure you are paying a “reasonable” wage to yourself. The IRS says, “An S corporation shareholder who performs more than minor services for the corporation will be its employee for tax purposes.”
This means that you wear both the hat of the shareholder, and the hat of an employee. As an employee, the IRS expects you to pay a “reasonable” wage to yourself. Luckily, or unluckily, (depending on whether you are a glass is half full or half empty type of person) the IRS does not define what is “reasonable”. There is no magic formula used to ensure the wage amount is “reasonable.” Which means there is also no magic formula to prevent an audit trigger on your S corporation tax return.
We do know that the IRS looks at everything on a case-by-case basis. Here are some factors you should be considering when deciding if the w-2 amount you pay yourself is “reasonable”. (Remember, we want the w-2 amount to be as low as possible while still being “reasonable” in order to save self-employment tax).
- the duties performed by the employee
- the volume of business handled
- the type of work and amount of responsibility
- the complexity of the business
- the time and effort devoted to the business
- the timing and manner of paying bonuses to key people
- the cost of living in the locality
- the ability and achievements of the individual employee performing the service
- the pay compared with the gross and net income of the business, as well as with distributions to shareholders
If you asked 10 CPAs what your “reasonable” wage should be, you will get 15 different answers.
That is what happens when the tax code is not clear on something. We start our analysis with the business net income. If other people exist in the business that drive income (like other employees or contractors) then I will take 25% of net income as a starting point for the “reasonable” test. If the business owner is the only employee, then I start with 30% of net income. Sometimes, that’s as far as you have to go. Depending on the above factors though, adjustments are often made. Again, there is no magic solution to this. All we know is that you do need to pay yourself something.
It’s common for S Corporation owners to find themselves in trouble because they don’t pay themselves wages. In fact, the best way to get audited is to not issue yourself a w-2 at all.
If you have an S Corporation, check with your proactive CPA to see if your wage is reasonable.