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 on a quarterly basis. 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 a reasonable salary, several approaches can help determine the different risks and benefits:
- Market method: Compare the salary of the S Corp owner to that of other professionals in similar roles, industries, and geographic locations.
- 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, involving an assessment of 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 health and wellness practitioners, 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 health and wellness practitioners 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's 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 primary benefit of an S Corp, as these "passthrough profits" are taxed just like income, with no self-employment or payroll tax assessed federally. Some states may impose additional franchise, business, or replacement taxes at the state level, but these are generally 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 an 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 Heard's Allocation Guide to help you determine the appropriate amounts. This is our recommendation for increasing your income without a significant salary increase.
Since the distributions are a return on your investment, it's best practice to ensure your distributions don't have ties to paying your personal bills. You can take distributions at any time the net profit supports it.
The general rule of thumb for Shareholders' Distribution limitations as an S-Corp is that you do not want to take more Shareholders' Distribution than you have in business profits.
The reason there are limitations is that the IRS can impose a tax on the "gain" if you withdraw more funds than the equity in your business. They would rather you take more in payroll (and pay payroll taxes on it) than take it out in Shareholders' Distribution.
Considerations
- Depending on when you become an S corporation during the year, you may need to run a catch-up payroll to ensure accuracy and compliance. Heard can help you initiate an off-cycle payroll to catch up for the quarter you are setting up.
- Please note that you will pay personal quarterly estimated taxes on the net profit, not distributions. You are not taxed on distributions; you are taxed on the net profit that passes through the S Corp to your personal return. Quarterly tax estimates for S Corporations
Please contact Heard to request guidance on reasonable compensation and owner distributions, and visit our resources on Becoming an S corporation.