All business owners face an interesting challenge: how to take profits out of the company and pay the least amount of taxes in the process. If you have an S corp., there are basically two ways you can get money out of the company: by paying yourself salary or by paying yourself distributions. The big difference, of course, is that distributions are tax-free and far more flexible (i.e. the company simply writes you a check). Meanwhile, salaries are subject to employment taxes (approximately 15%) and the usual payroll-related bureaucracy (withholding, etc.).
So why don't business owners simply take 100% of their profits as distributions and forget salary altogether? The reason can be summed up in three words: reasonable compensation rules. If you own an S corp., the IRS has guidelines governing how much you are supposed to pay yourself. Here's how the rules work and the key points to keep in mind.
How the Rules Work
The IRS is well aware that business owners don't like paying taxes. Therefore, they have established a set of rules requiring companies to pay "reasonable compensation" to their owners. In a nutshell, these rules are designed to prevent you from avoiding taxes by taking all of your profits as distributions. The IRS' basic argument is that nobody works for free (even the owners) and therefore you are required to pay yourself reasonable compensation for services performed. That number is generally based on several factors including hours worked, reasonable rate, industry averages, and what's being paid to other employees.
The reality is that most S corp. owners want to pay as little as they can get away with in salary and then take the majority of profits as distributions (after all, that's one of the biggest advantages of electing an S corp. in the first place). Nevertheless, determining the right (i.e. minimum) amount for owners' salary can be tricky business because the rules leave a lot of grey area. Generally speaking, here are the key points to keep in mind:
1) Zero salary is a red flag: For example, if you worked full-time in your S corp. last year and paid yourself $90K in distributions without taking any wages, that's a no-no. The IRS notices when owners take no salary.
2) The 60/40 rule: Many CPAs advise their customers to play it safe by following the 60/40 rule: take 60% as salary and 40% as distributions. The basic idea here is that salary should never be less than distributions. This ratio obviously doesn't apply in every situation, but it can be a useful rule of thumb in some cases.
3) Distributions must be pro-rata (i.e. based on ownership percentage): In other words, if there are two 50/50 owners and the S corp. made $100K profit last year, you can't pay one owner $80K in distributions and the other owner $20K. They have to be treated equally.
Remember, these are general rules. Please call us to schedule an appointment for a more in-depth look at your specific situation.