Owner Compensation in an S-Corporation

One of the tax attributes of an S-Corporation over other forms of tax entities is the ability to reduce the overall tax obligation. Naturally the lower the overall tax requirement the more profit generated for the owner(s). The S-Corporation allows an owner to reduce their tax responsibility via the compensation package assigned to the owner. The lower the salary, the less Social Security and Medicare taxes have to be paid to the Internal Revenue Service. In addition, the company doesn’t have to match those Social Security and Medicare Taxes and now the owner saves even more money. Many owners of small business operations use the S-Corporation status to reduce their overall tax situation via this tool.

The Internal Revenue Service is acutely aware of this and uses several monitoring systems and analytics to determine when an S-Corporation abuses this privilege. If an owner fails to comply with the tests of reasonableness, the IRS imposes penalties and fines. Continued abuse results in loss of S-Corporation status and in some instances, criminal charges. This article explains the overall tax scenario related to an owner’s compensation package in an S-Corporation and the corresponding employment taxesI’ll continue by explaining the primary tests of reasonableness based on the type of business operation, that is, capital or service based. Next I’ll finish up with some IRS guidance on the subject matter. Finally, I’ll provide to you a reasonable schedule to follow that complies with the IRS regulations and helps you have greater access to capital.

This article is in-depth and explains this compensation issue in detail. For those of you desiring some quick and easy answer, I’ll be poignant: PAY YOURSELF ALL THE PROFITS AS COMPENSATION AND THE IRS WILL NEVER BOTHER YOU. Even more, if you totally desire to avoid all taxes, you can just send me all your profits and I’ll gladly pay the taxes and you will not have to pay a dime of tax; I Guarantee It! But this is unrealistic and so it is beneficial to you to understand the entire picture so that you pay yourself appropriately and comply with the law. This article gives you the insight and guidance to comply with the law.

Let’s start out by explaining the Social Security and Medicare tax relationship with income.

Implications of Employee Taxes and Employer Matching Taxes

In a basic business operation the owner of the company is self-employed and does all the work. This is how most businesses start out. Any net income earned requires the owner to pay income taxes and Self Employment Taxes. The Self Employment tax is simply a 15.3% tax on all your earnings when you are a sole proprietor. It is very similar to the tax imposed on regular employees. When an employee is paid, 7.65% of his paycheck is withheld for Social Security and Medicare purposes. The employer is mandated by law to match this tax and so the total tax is 15.3% (7.65 + 7.65 = 15.3).

When a company incorporates, the owner generally shifts from self-employment to regular employment. The only difference is now the owner is an employee of a company he actually owns. Indirectly it is similar to being self-employed. The only real difference is that instead of paying the self-employment taxes via estimated payments the owner uses the tax reporting system of filing Form 941’s in a quarterly fashion. By the way, the term accountants use for these Social Security and Medicare taxes is FICA. FICA stands for Federal Insurance Contribution Act; the federal law imposing the requirement to pay Social Security and Medicare taxes on both the employee and employer.

Now the owner looks for some advice from his accountant and the accountant mentions that hey, why don’t we pay you less and therefore you don’t have to pay as much in FICA taxes. What a great idea! If I pay myself $10,000 less per year I’ll save $1,530 in FICA taxes. In addition, I’ll save $10,000 as regular income to me on my Form 1040 and if I’m taxed at the 15% tax rate I’ll save another $1,500. My total savings is $3,030!

Seems like a great way of reducing your overall tax obligation. The problem is that if your personal wage is $10,000 lower, than the net income for the company is $10,000 higher and regular corporation tax rates range between 15% and 34%. You end up paying $1,500 more in regular income taxes at the corporate level to save $3,030 in FICA and income taxes at the personal level.

Seems to be a pretty good deal if you ask me? But there is a problem here. As the company grows this tax rate shifts from 15% to 25% and ultimately to 34%. Now you are paying even more income taxes ($3,400) than the savings you achieved via the lower gross wage. And to add insult to injury it doesn’t take a lot for the company to pay taxes at 39% tax rates. Thus, you actually end up paying more overall taxes. It is even worse because any net profit after taxes in the company that you want to take home is TAXED AGAIN at your individual tax rates via the dividend tool used to report the payment of profits of a company to the owner. That mere $1,530 of FICA savings turns into more than $3,000 of income taxes.

Crud! This isn’t going to work; we need some other tool to reduce our overall tax obligation.

Well, along comes the S-Corporation and its corresponding tax attributes.

S-Corporation Tax Attributes

The number one reason for incorporation is to separate the legal issues related between an individual and a legally recognized entity. For tax purposes the IRS basically grants the tax status of a business as an individual and still allows you to be legally separate as an entity. This is the S-Corporation. Many folks use this tax status to file information based taxed returns, Form 1120-S, and still have legal protection in case of lawsuits and actions by other parties.

The S-Corporation basically allows the net income of the business to flow directly to the owner via Schedule K-1. In effect, any net income is assigned to the social security number of the owner and this person must pick up this income on their Schedule E attached to their Form 1040.

Notice what happens here, instead of the company paying the taxes, the individual pays the income taxes on this net income. In the regular corporation format, the company pays the taxes but when you take your profits from the C-Corporation, these profits are taxed again as dividend income at the individual level. But with an S-Corporation, you don’t issue dividends, you pay out net profit using DISTRIBUTIONS. These distributions are tax free because you have already paid the income taxes on those profits via the assignment of the income to you via Schedule K-1.

I know, you are saying out loud: “This is getting confusing; how is this applicable to the FICA issue?”

OK I’ll explain. Now let’s go back to that $10,000 reduction in salary from above. Basically that $10,000 is not taxed for FICA or corporation income taxes but is only taxed at the individual level as income tax typically at a rate of 15%. So the overall cost of this $10,000 reduction in salary is $1,500 in income taxes and not $3,030 for both income and FICA. Total savings is the $1,530 of FICA taxes.

Hey, this is a great idea. Why not just pay ourselves ZERO and save all the FICA taxes?

This is where the IRS steps in and says, ‘Hey wait a minute, remember why you were granted the S-Corporation status, it isn’t designed to eliminate or reduce your FICA obligation, it is designed to grant you legal protection by your state’s laws and for you to continue paying taxes as if you were self-employed’.


Alright, this makes sense but not all of my earnings are directly attributable to my actions. I actually have employees that assist me and I use equipment to perform my work. I shouldn’t have to pay FICA taxes on what these folks and tools provide to the company. Shouldn’t this be just taxed at my income tax rate and not both? The IRS agrees because several court cases justify this approach towards taxation. These cases include:

  • Watson v. Commissioner, 668 F.3d 1008 (8th, 2012) – Watson provided professional services and paid himself a mere $24,000 a year in salary and received distributions from profits of over $175,00. The Court ruled that Watson must match his salary to what other similar professionals were making in the similar geographical zone. The Court ruled that Watson’s reasonable salary is closer to $93,000 per year and therefore is obligated to pay payroll taxes on the $69,000 difference. The maximum amount of FICA based payroll was limited to the amount Watson generated as revenue for the firm. The net income generated by other employees and equipment is taxed at regular income tax rates.
  • Sean McAlary LTD. v. Commissioner, T.C. Summary Opinion 2013-62 – In this case the Court concluded that the primary owner of this company should receive a salary of not less than $40 per hour for the time he spends on his successful business operation. This is one case where the court uses a monetary figure as the standard of performance. All other net income is attributable to other attributes of the business and therefore taxed at the traditional income tax rates.
Key Business Principle

In the history of cases involving S-Corporation compensation to the owners there have been over 25 opinions rendered by the Court. NOT A SINGLE ONE was in favor of the owners of these types of tax entities. Lesson to be learned: YOU ARE NOT GOING TO WIN IN COURT!

What do stand out in these cases are the different forms of operations of the various companies. The court and the IRS agree in how they are treated related to their respective form of operation. The more capital intensive the operation the less reliance on the owner as the primary generator of income is the formula based.

Capital or Service Intensive

With service based industries such as professional firms, it is very difficult for the company to prove that the net income is based on other staff members over the owner. Actually the smaller the operation the more likely the net income is tied to the owner’s services. The IRS relies more extensively on the Social Security threshold as the minimum compensation for the owners of successful professional service operations. The current (2020) Social Security earnings ceiling is $137,700. Basically, any earnings for the owner in excess of $137,700 is no longer taxed for Social Security and the corresponding matching tax which for a total of 12.4%. Any earnings in excess are taxed for Medicare purposes only. However, professional service operations are allowed to use a salary basis for similar full time professionals in the same geographical zone as the compensation value. Any net profit in excess is attributable to the staff of the company.

If your company is a professionally based operation the answer to the question is:  you must pay yourself a minimum of $137,700 or the total net profit up to $137,700 to stay out of the IRS’s radar. Examples of professional service based businesses include:

  • Legal, Accounting, Architectural Firms
  • Barber, Hair Stylists, Personal Grooming Operations
  • Medical Professionals to include Dental, Eye and Chiropractors
  • Mental Health Professionals
  • Business Consultants
  • Sales Representatives

At the other extreme are those operations that are capital intensive. Think of site developers or manufacturing companies; even real estate landlords.  In these cases, it is easier for the owner to demonstrate that the net profit is tied more to the equipment than to his services. Therefore the net income should be taxed for income purposes only and not assigned to the owner as salary.  In these situations, the owner should document his time to the company and pay himself no less than $50 an hour. This alleviates the concern that the IRS will examine your situation. Most small business owners will work 2,400 to 2,600 hours per year in these companies. At $50 an hour, you are looking at a salary base of $105,000 to the $137,700 Social Security ceiling. For those owners that do this part time, you may want to consider a higher dollar amount per hour to the $60 or $70 range and have some form of documentation for the number of hours you work.

Any business operation between these two extremes, the key is to use the test of reasonableness. If you are a truly small operation and netting before your salary less than $120,000 per year in income; you should consider using 75% as salary and the balance as net income. You can also use the substation principle as the basis for your reasoning. How much would you pay for another person to come in and manage the business as you do? This should be your salary.

The IRS uses other tools to calculate a reasonable salary.

IRS Guidance

In general the IRS looks to the Code and the court decisions made in regards to this issue. Since many S-Corporations are single shareholder owned and this shareholder performs substantial services comparable to an employee the IRS uses the substitution principle to determine a fair wage for services rendered. In general the IRS uses financial ratios as published by the Risk Management Association to determine the compensation package assigned to the employees of a company. If a company’s overall payroll is less than the standard ratio, the difference must be related to the services rendered by the management team or most S-Corporation cases, the owner(s). Other tools include guidance in industry manuals or other governmental guidance manuals. They may even consider using worker’s compensation insurance formulas to determine a fair wage to the owner.

Another tool used by the IRS is Section 3121(d) of the Code. This section qualifies an officer of a corporation as equivalent to an employee. Therefore, any owner who is an officer is also an employee. The only exception to this is if this officer provides minimal duties to the company. An example would be showing up annually for a meeting of the shareholders to elect officers or the management team. If the owner/officer has little to no duties in the company, then yes, their income can be solely related to the net profits of the company.

There are many factors considered in determining what is fair for an owner/employee. These factors include:

  • Experience/Skills/Knowledge
  • Time and Physical Effort Devoted to the Business
  • Credentials/Licenses/Certifications/Credit
  • Overall Responsibilities

For the IRS, their focus is the substitution principle, i.e. what is the compensation paid to the owner/manager in comparison to someone fulfilling the same role but as a non-owner.

What intrigues me the most is that if you look at the overall tax situation for any well performing business, the whole thing is actually irrelevant. This tax savings quest is really only an issue with very small or underperforming operations. At the end of the day, your goal as an owner is to generate real value via profit. If you have a small business that generates less than $150,000 of profit before considering your salary, this is an issue. You should just simply use the $50 an hour as your guideline. Set your salary ceiling at the Social Security ceiling of $137,700 and focus on making more profit.

If your business is making less than $50,000 per year as profit before your salary and you are working on this on a regular basis; you should simply pay yourself the entire amount as a wage. You really need to work on a way to make more money.

For those operations in excess of $150,000 a year in profit before salary, allow me to illustrate why it doesn’t matter to you. Just pay yourself the $137,700 and move on.

A Reasonable Schedule

Let’s take a look at a situation where the business generates $175,000 per year before the owner takes any salary. Let’s compare the differences between an owner taking a $60,000 per year salary, against a $137,700 a year salary. Again, the owner is very active and is considered the key man in the company. Therefore there is no possibility that a salary of less than $60,000 per year will be acceptable to the IRS.

                                          $60,000 Salary    $137,700 Salary
Income Tax on Salary                9,000                 20,655
FICA Taxes                                9,180                 21,068
Balance of Net Earnings         115,000                37,300
Less: Business Match Tax          4,590                10,534
Taxable Net Earnings             110,410                 26,766
Tax on Net Earnings @15%     16,561                   4,015
Total Taxes Paid                      $34,742               $45,738

The difference in taxes paid between the two salary levels is $10,996.  Basically this is the FICA tax on the salary difference ($77,700 * 15.3%). What is important to understand is that as the overall net income goes up the differential in tax remains at $10,996. Thus, as the company makes more money the more likely it is that the company will need to pay the owner the Social Security ceiling value as compensation. As you earn less than $150,000 before compensation the more likely and justifiable it becomes to lower the salary and go back towards $60,000 as the owner’s earnings.

At $50 an hour, the owner will make around $104,000 per year. Therefore, the real ‘TAX PENALTY’ associated with paying the Social Security ceiling value and the $104,000 is the FICA tax on the difference. In effect the real difference or maximum savings to use the S-Corporation to reduce your tax obligation is 15.3% on $33,700 lower salary or $5,156.

Think about this for just a minute. You want to risk losing your S-Corporation status with the IRS over $5,156 per year when your company is netting more than $175,000 a year in net profit before paying compensation to the owner. You already pay legal fees to maintain the company’s status with your state and you pay a CPA to prepare your tax returns and yet you will risk it for $5,156? Remember, if you lose your S-Corporation status the total tax obligation is going to run around $55,000 or $12,000 more than an S-Corporation paying the owner the Social Security ceiling amount of $137,700.

What is even more interesting is that if you run your business appropriately, you will have some form of a retirement plan in effect; like a 408(p) plan called the SIMPLE Plan. If you deduct 6% of your salary, the difference in your contribution of $33,700 * 6% is $2,022 and this will save you an additional $303 in income taxes. Now we are really talking about $4,853 in taxes.

Now I know a lot of you are saying to yourself, ‘DAVE, THAT IS A LOT OF MONEY’. OK, I agree. Let’s be reasonable here. Use the following table as a guideline and I can assure you that you will not have any problems with the IRS:

Net Earnings Before Owner Compensation – Up to $50,000; pay 100% as owner compensation
Net Earnings Before Owner Compensation – Between $50,000 and $180,000; pay a salary to the owner of 75% of the net earnings
Net Earnings Before Owner Compensation – Greater than $180,000; pay the Social Security ceiling amount which is currently $137,700.

You can’t go wrong with this formula; nobody will challenge you and it will definitely hold up in court as the Tax Court has used $50 an hour as an acceptable compensation for an S-Corporation owner.

If you go back to my example and use $150,000 as the net earnings before owner compensation for your company; how much should you pay the owner and what is the total tax liability?

Answer: The owner is paid 75% of $150,000 or $112,500. The total tax on this is as follows:

FICA               $17,213
Income Taxes    21,209
Total Tax         $38,422

Compare this against the total tax on a minimum $104,000 ($37,212) and you get a tax difference of $1,210. OK, this is more reasonable and a good schedule to follow.

But do I get any value for this additional tax of $1,210 at this level? Believe it or not, you get more value than you realize.

For starters, your W-2 reports greater earnings and all outside creditors understand Form W-2. Outside creditors have a difficult time and even refuse to consider Schedule K-1 information. Folks like bankers, mortgage lenders, auto creditors, equipment creditors and even American Express rely greatly on the W-2 as their primary source of personal indication of earnings for the applicant. I never realized this until I saw it in action for a client. The client applied to the bank for a business loan to purchase new equipment and a newer truck. The bank demanded recourse which is normal and looked at the owner’s sources of income. The year his W-2 identified $50,000 as his gross wage and his K-1 reported $55,000; they totally ignored the K-1 and based their decision on the W-2.

Using this knowledge, I had him change his earnings to $90,000 and his K-1 ended up at $40,000 the following year. He applied for a line of credit to purchase a lot and sure enough the bank relied on his W-2 as the primary indicator of income to pay the interest on the loan. Not an issue; he got his line of credit! Was it worth it to pay the additional $6,120 in taxes on that $40,000 difference? In his case, yes, he had no problem getting a loan and furthermore the bank would call him every now and then to see if he needed to borrow more.  Figure that one out?

Wealth accumulation is controlled by many different parties and paying a little more in tax goes a long way to having access to capital when you need it most. In addition, greater owner compensation reduces any worry about the IRS knocking on your door. Be wise and reasonable in how much you pay yourself as an owner of an S-Corporation. Act on Knowledge.

© 2015 – 2022, David J Hoare MSA. All rights reserved.

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