Avoid Trouble: Don’t Let the IRS Set Your S Corporation Salary

You likely formed an S corporation to save on self-employment taxes.

If so, is your S corporation salary

• nonexistent?
• too low?
• too high?
• just right?

Getting the S corporation salary right is important. First, if it’s too low and you get caught by the
IRS, you will pay not only income taxes and self-employment taxes on the too-low amount, but
also both payroll and income tax penalties that can cost plenty.

Second, in most cases, the IRS is going to expand the audit to cover three years and then add the
income and penalties for those three years.

Third, after being found out, you likely are now stuck with this higher salary, defeating your
original purposes of saving on self-employment taxes.

Fourth, your tax advisor can get slapped with preparer penalties.

Saving on Self-Employment Taxes

For 2021, self-employment taxes are assessed as follows:

1. The first $142,800 of self-employment income is taxed at 15.3 percent.1 To get to self-employment income, you multiply net income by 92.35 percent. Planning note. This means that your potential savings at the maximum self-employment tax rate occurs on up to $154,629 of your 2020 net income ($142,800 ÷ 92.35 percent).
2. For amounts of self-employment income between $142,800 and $200,000, you get hit with the 2.9 percent Medicare tax.
3. For amounts of self-employment income in excess of $200,000 ($250,000 on a joint
   return), you get hit with a 3.8 percent tax (2.9 percent for Medicare and 0.9 for
   Obamacare).

Self-employed. Your biggest savings occur when you can encroach on the 15.3 percent. You
trigger these savings at the rate of 14.13 percent for every dollar below $154,629.3 This is how
you should think as a self-employed person who is considering becoming an S corporation.

S corporation. But once you are an S corporation, you save on payroll taxes with salary below
$142,800, which are assessed at 7.65 percent on the employee (you) and 7.65 percent on your
corporation, for a total savings of 15.3 percent.

Example. Sam takes a cash salary of $37,700 and an S corporation distribution of $100,000. His
payroll tax savings are $15,300.

Don’t judge Sam’s cash salary as too low yet. It might be okay, as you will see later in this
article.

Do This

Put yourself in the IRS examiner’s chair. You ask an S corporation owner-employee, for example, “What’s your basis for the $63,231 salary?”

What would you (remember, you are the IRS examiner) like to hear and see so you can accept
the salary as reasonable?

We don’t know for sure because, as the IRS says in its Fact Sheet “Wage Compensation for S
Corporation Officers:”4

There are no specific guidelines for reasonable compensation in the Code or the Regulations.
The various courts that have ruled on this issue have based their determinations on the facts and
circumstances of each case.

But you have to believe that having the dollar amount of the reasonable compensation in a
written document that’s included in the corporate minutes creates a great first and perhaps lasting
impression.

The minutes take on additional meaning if they contain a reasonable compensation document
that’s updated annually.

Getting to the Number

The IRS did you a big favor when it released its “Reasonable Compensation Job Aid for IRS
Valuation Professionals.”5

The IRS states that the job aid is not an official IRS position and that it does not represent
official authority. That said, the document is a huge help because it gives you some clearly
defined valuation rules of the road to follow and takes away some of the gray areas.

Three approaches. The job aid lists three general approaches to reasonable compensation:

1. Market approach
2. Income approach
3. Cost approach

Market Approach

The market approach to reasonable compensation compares the S corporation’s business with
others and then looks at the compensation being paid by those businesses to employees who look
like you, the shareholder-employee who is likely the CEO.

The question to be answered is, how much compensation would be paid for this same position,
held by a non-owner in an arm’s-length employment relationship, at a similar company?

In its job aid, the IRS states that the courts favor the market approach, but because of challenges
in matching employees at comparable companies, the IRS developed other approaches.

For how the market approach works, see David E. Watson, P.C. v. United States6. In this case,
you see the following:

1. Mr. Watson’s S corporation paid him a salary of $24,000 and distributions of $222,000.
2. The IRS audited Mr. Watson’s S corporation tax return, disallowed the $24,000, and
   asserted $199,000 as the reasonable salary.
3. Mr. Watson took the IRS to court.
4. Mr. Watson left the courthouse with $91,000 as salary, leaving $155,000 in profit
   distributions.

Mr. Watson saved big on his payroll taxes.

Income Approach

The IRS says the income approach, which is based on the independent investor test, can be
correctly applied only when the fair market value of the company is available for each year that
compensation is being examined. As a result, the market approach is generally more useful than
the income approach in a reasonable compensation analysis.

For how the independent investor test works, see Brinks Gilson & Lione A Professional Corp. v.
Commissioner7. This case involved a law firm that operated as a C corporation and bonused out
the profits each year.

After negotiations, the IRS and the law firm entered into a closing agreement that, among other
things, disallowed those year-end bonuses and recharacterized them as non-deductible dividends.
This resulted in tax underpayments of $1,109,652 and $1,015,776, respectively, for each of the
two years under examination.

 S and C corporations. The reasonable compensation issue applies to both the S and C
corporations, albeit there will likely be fewer C corporation issues now that the C corporations
have a top tax rate of 21 percent. But the following applies, in general:

• The owner of an S corporation wants a low salary.
• The owner of a C corporation wants a high salary.

The IRS job aid deals with both the too-low and the too-high salary issues.

Cost Approach

The cost approach breaks your employee activities into their components, such as management,
accounting, finance, marketing, advertising, engineering, purchasing, janitorial, bookkeeping,
clerking, etc.

The IRS, in Appendix H to its job aid, lists five court cases wherein the courts agreed with the
IRS’s cost approach in finding the compensation to the C corporation shareholder-employees too
high, but disagreeing on the dollar amount of the reasonable compensation.8

With the S corporation, you are generally looking for the low salary to save on payroll taxes. The
cost approach can provide excellent proof for the various jobs that you perform as a shareholder-employee of your S corporation.

We found a resource at https://rcreports.com/ that could prove valuable in establishing a
reasonable salary for the shareholder-employee. We have no relationship with this resource, but
we are familiar with some tax professionals who use it to assist their clients. We are also familiar
with the databases it uses to generate the compensation levels.

Here's an example of how the cost approach works to support a $71,019 salary as reasonable
compensation for this S corporation owner whose corporation had $3.5 million in revenue and 19
employees:

Health Insurance

The S corporation’s payment or reimbursement of health insurance for the shareholder-employee
and his or her family goes on the shareholder’s W-2 and counts as compensation, but it’s not
subject to payroll taxes so it fits nicely into the payroll tax savings strategy for the S corporation
owner.

Pension

The S corporation’s employer contributions on behalf of the owner-employee to a defined
benefit plan, simplified employee pension (SEP) plan, or 401(k) count as compensation but don’t
trigger payroll taxes. Such contributions further enable the savings on payroll taxes while adding
to the dollar amount that’s considered reasonable compensation.

Planning note. Your S corporation compensation determines the amount that your S corporation
can contribute to your SEP or 401(k) retirement plan. The defined benefit plan likely allows the
corporation to make a larger contribution on your behalf.

Section 199A Deduction

The S corporation’s net income that is passed through to you, the shareholder, can qualify for the
20 percent Section 199A tax deduction on your Form 1040.

Takeaways

If you want your S corporation salary to hold up in an IRS audit, do two things:

1. Make sure the corporate minutes name your salary.
2. Have documents that prove your salary is reasonable

The question is, who will set your salary—you or the IRS? With documentation, you put
yourself in the driver’s seat.

Both you and the IRS have two viable approaches (from the three in the job aid) to finding the
reasonable salary for the S corporation owner-employee:

1. Market approach
2. Cost approach

Regardless of the approach used, if you have (1) the salary in the S corporation minutes and (2)
documentation that proves your salary is reasonable, you can sleep well at night.

1 Social Security Administration Fact Sheet 2020 Social Security Changes.

2 IRC Section 1401(b)(2).

3 To find self-employment income, you multiply net income by 0.9235 percent. 15.3 percent x
0.9235 percent = 14.13 percent.

4 FS-2008-25, last reviewed or updated: Mar. 4, 2020.

5 “Reasonable Compensation Job Aid for IRS Valuation Professionals” (Oct. 24, 2014).

6 David E. Watson v U.S., 107 AFTR 2d 2011-311 (DC IA, 12/23/2010).

7 Brinks Gilson & Lione A Professional Corp. v. Commr., T.C. Memo 2016-20.

8 Appendix to “Reasonable Compensation Job Aid for IRS Valuation Professionals.”