As we have discussed in previous blog posts, one of the compliance requirements of being an S-Corp is that the owner pay themselves a “reasonable salary.” Unfortunately, that is where the guidance stops, and there is no recommendation or metric to determine the correct amount in proportion to the S-corp’s income. This requirement may seem arbitrary, but there are very specific reasons for it, as well as benefits that come out of paying yourself a salary.
S-Corp Compliance – Why is Salary Required?
It is required for an S-corp owner to take a salary because, unlike an LLC, Partnership, or Sole Proprietor, an S-corp is taxed net of self-employment tax; meaning that the S-corp’s income earned is not subject to self-employment taxes. However, the IRS still requires its 15.3% tax. Therefore, the owner must pay themselves an appropriate amount of salary on which self-employments taxes are levied. This is where the balancing act comes in with assigning an appropriate amount of salary versus the total amount of revenue earned.
It is recommended that owners work with an accounting professional to come up with a suitable number. Happily, the salary amount is not locked in from the beginning of the year, and may be adjusted throughout the year. We at BalanceMonkey typically find that 50% of net income is a safe ratio.
What Benefits does Taking a Salary Give?
Even beyond the tax saving, the benefits of taking an owner’s salary tend to outweigh the hassle. One of the easiest to overlook, is that an owner can reign in their spending if they tend to spend everything they earn. If the owner is a real estate agent who went from making $60,000 in a year, to making $240,000 the next year, there is a tendency to increase lifestyle and spending habits proportionally, which doesn’t ultimately build sustainable and long lasting wealth. By placing yourself on a reasonable salary, you can more easily enforce a budget.
Additionally, having a monthly, or even a quarterly payroll can help an owner get a new loan or mortgage. If the lender only has the previous year’s financials to go off of, it is hard to prove that you are a great loan candidate. A paper trail of paystubs, and a W2 go a long way towards improving your standing at the bank.
Another benefit is the access to new retirement strategies. As an employee on someone else’s business, you would be limited to whatever 401K or IRA benefit was provided. Alternatively, when you are the owner of a business, you can make your ‘employee benefits’ exactly how you want them. Not only can you contribute to a 401K or IRA, but the company can contribute as well! As the owner, you also have access to strategies like a Cash Balance Plan, to defer earnings, as well as other methods to really maximize your retirement planning. If you are getting a late start on your retirement savings, there are methods to be able to set aside far more than is allowed by traditional IRA and 401K contribution caps.
The Bottom Line
While the work of taking a salary can feel burdensome, that salary is the mechanism that allows the S-Corp to save on Self Employment Taxes. It is only because of the salary that the remaining earnings can be removed from the company Self Employment Tax free.