As an S Corporation owner, the IRS requires you to pay yourself a reasonable salary through regular payroll with tax withholding remitted to the IRS quarterly. Reasonable compensation refers to the amount you would need to pay an external employee to perform your responsibilities within the business.
Methods for calculating reasonable compensation
While the IRS doesn't mandate a specific method for calculating reasonable salary, several approaches can help determine with different risks and benefits:
- Market method: Compare the salary of the S Corp owner to what other professionals in similar roles, industries, and geographic locations earn.
- Cost method: Calculate the value of the owner’s contribution based on the time spent and the cost of hiring someone to perform similar tasks. This is also sometimes called the "many hats" method, as it involves estimating the time spent per year across several different categories of tasks and the typical compensation associated with those tasks to arrive at a figure for reasonable compensation.
- Income method: Allocate a portion of business profits to the owner as salary, ensuring it’s sufficient for tax compliance. Care needs to be taken to ensure that the compensation is still "reasonable," as it's possible using this method to arrive at compensation that the IRS wouldn't consider acceptable. One simplified version of this is the "60/40 rule", where 60% of your profits are allocated to your compensation and 40% is passthrough profits. However, the tax courts have found that the 60/40 rule isn't sufficient on its own to establish reasonable compensation.
- Independent Investors Test: This is the most complex method and involves assessing whether a hypothetical independent investor would accept the owner’s compensation based on the company’s return on investment (ROI).
Determining your reasonable salary
Heard will help you to determine a salary using the "Market" method as this method produces a compensation figure that is defensible if you're ever audited and is generally the simplest method for therapists as it doesn't require accounting for the time you spend across different functions within your business.
To produce your suggested reasonable compensation, Heard will:
- Review market data for therapists with your particular credentials in the area where you primarily operate
- Determine the average and aggregated compensation in that market
- Suggest a range of compensation that will satisfy the IRS' reasonable compensation requirement
Paying yourself a reasonable salary
After determining your reasonable salary, you'll need to pay yourself this wage via a payroll processor (either Heard Payroll or another service). A payroll provider service will simplify compliance and ensure proper withholding and remittance of payroll taxes to the IRS (and state revenue agency if applicable in your state. and the quarterly and annual payroll filings get filed properly.
S Corporation Tax Advantage
Remaining profits after you've covered your expenses and reasonable compensation will then pass through to your personal income tax return, which will be taxed as income when you file your annual income tax return. This is the main perk of S Corp as these "passthrough profits" are taxed just as income, with no self-employment or payroll tax assessed federally. Some states may have additional franchise, business, or replacement taxes assessed at the state level, but these are generally much lower tax rates than self-employment or payroll taxes.
By paying yourself reasonable compensation with payroll and income taxes assessed, your remaining profits are just taxed as income. This is one of the key benefits of S Corp.
Owner's Distributions
You can transfer passthrough profits from your business account to your personal account at any frequency; this is considered an Owner's Distribution You can use your Allocation Guide to help you determine the appropriate amounts. This is our recommendation to increase your income without significantly raising your salary. Increasing your reasonable compensation will reduce your tax savings due to the required payroll taxes to be withheld on this compensation.
There are some additional considerations when it comes to taking owner's distributions, so please be sure to contact Heard to request guidance on reasonable compensation and owner's distributions. Depending on when you become an S corporation during the year, you may need to run a catch-up payroll. Heard can help you initiate an off-cycle payroll in order to catch you up for the quarter you are setting up.
For more, please see FAQs about therapists' reasonable salaries and visit our resources on Becoming an S corporation.