S-corp payroll: reasonable compensation

The rule

Shareholders who perform more than minor services for an S-corporation are employees. Before the company distributes profit to them, it must pay them W-2 wages that reflect reasonable compensation for the work they do. There is no safe-harbor percentage in the tax code; “reasonable” means roughly what the business would have to pay someone else to do the same job.

The IRS and courts look at factors including:

• the owner's training, experience, duties, and responsibilities;
• time and effort devoted to the business;
• what comparable businesses pay for similar services;
• the company's gross receipts, profits, and dividend history;
• how salary and distributions have been split over time.

What happens if you get it wrong

Courts have repeatedly upheld reclassification. In a well-known case, an accountant who paid himself $24,000 in salary while taking over $200,000 in distributions had a large part of the distributions treated as wages, with employment taxes and penalties owed on the difference. A $0 salary with large distributions is the pattern most likely to draw scrutiny.

Going too high has a cost too: every salary dollar above reasonable pays payroll tax the S election was meant to save. The goal is a defensible number, not the lowest one.

Setting a defensible salary

1. List the roles you actually perform, for example, 60% software engineer and 40% general manager.
2. Price each role using market data: Bureau of Labor Statistics wage data for your metro area, salary surveys, or offers you've seen for similar work.
3. Weight by time spent and adjust for part-time hours.
4. Write a one-page memo with the sources and keep it with your tax records; update it when your role or the business changes.

If the business can't yet afford a market salary, a lower wage can be reasonable, but taking large distributions at the same time undercuts that argument.

The payroll machinery

• Payroll provider (Gusto, Rippling, ADP, or similar) to run pay, withhold, and deposit taxes on schedule.
• Federal: Form 941 quarterly, Form 940 annually for unemployment tax, and W-2/W-3 by January 31.
• California: register with the EDD; withhold state income tax and SDI; pay unemployment insurance and the employment training tax; file DE 9 and DE 9C quarterly. Other states have their own equivalents.
• Health insurance paid for a more-than-2% owner is added to their W-2 wages (it's exempt from Social Security and Medicare) and they may deduct it personally.

Worked example

A consultant's S-corp earns $180,000 of profit before owner pay. With a documented $100,000 salary, the company pays about $7,650 of employer payroll tax and withholds the same from the owner: about $15,300 total. The remaining ~$72,000 of profit comes out as distributions free of payroll tax. As an LLC, nearly the whole $180,000 would have been subject to self-employment tax. Net savings depend on the Social Security wage base, state unemployment costs, and provider fees, typically several thousand dollars a year at this level, which is why the election pays off once profit comfortably exceeds a market salary.

Compare the California side in LLC vs S-corp with math and read the election guide before filing Form 2553.