Many of us dream of being told to “name our salary,” but for small business owners across the U.S. that dream-worthy question can also present a few nightmares. As a business owner, particularly one operating an S-corp, determining your salary requires you to navigate a complex web of circumstance and red tape.
By design, S-corps allow small business owners to pass income and losses through their corporation and to their personal taxes. This allowed business owners to pay themselves through corporate distributions as opposed to salaries, effectively circumventing hefty Social Security and Medicare taxes that are typically associated with salary and hourly compensation.
Unfortunately, some see this as a green light to consistently forgo paying taxes, and as one may assume, that doesn’t sit well with the IRS. To remedy this problem, the IRS requires shareholder-employees to receive “reasonable compensation” for services provided, and that this must be paid “before non-wage distribution may be made.”
In other words, you should be paying yourself the same amount you’d pay someone to come in and take your responsibilities. Failure to do so can lead to big penalties come tax time, as the IRS will compare your salary earnings with your dividend earnings.
It sounds simple enough, but alas, this is where things tend to get confusing, and so to help us out, we turned to Paul Hamann, the founder and president of RCReports.com, an online application for establishing Reasonable Compensation for shareholder-employees of S-corps.
Hamann is quick to admit that on the surface, the answer to “how much should you pay yourself” seems simple: the net profit. But he’s equally quick to point out that “most of the time, people get confused when you start to add in accounting and tax implications.”
Rightfully so. For many of us, tax liability is confusing enough, but when you factor in things like startup costs, typical organizational overhead, and seasonality, things quickly shift from black and white to that familiar and often convoluted shade of gray.
Here are a few ways you can begin to navigate the complexities of determining your salary.
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1. Determine Your Value
If you were to replace yourself, how much would you pay your replacement? As Hamann points out, that’s not always an easy thing to determine, as many small business owners wear their share of operational hats.
To get a good idea of what your “worth,” you’ll need to do some research. The Bureau of Labor and Statistics, Glassdoor.com, and Salary.com are all great places to start your search. Keep in mind that salaries will vary by industry and location, so be sure to factor that into your research.
It’s also important to note that this will go a long way when it comes to pleasing the IRS.
2. Analyze Your Living Expenses
It’s fine to strive for a salary that will allow you to live in luxury—after all, you’re putting in all the hard work—but depending on your cash flow, that won’t always be easy. This is particularly true when you’re just starting out. Remember that you’ll want a cash cushion in your business banking account in case of any emergencies that may pop up in your business.
Evaluating what it costs to keep a roof over your head, food in the fridge, and bills paid can help you establish what you need to survive, and you can use that in conjunction with the industry salary standards associated with your position(s).
3. Work Closely With an Accountant
We cover this piece last because of its overwhelming importance for S-corp shareholders trying to determine their salary. Hamann says the CPA is the “most overlooked person,” and reminds business owners that CPAs deal with this type of question all the time, so they should strongly consider tapping that resource.
This is particularly true, he said, with regard to startups, which are often trying to save money. However, in his opinion, “it’s money well spent.” In fact, his software, which provides Reasonable Compensation Reports, is geared toward tax and financial advisors, largely because of the truly complex nature of the salary question.
The question of “how much should you pay yourself” is one that must be approached with a reasonable amount of research and analysis. Always keep in mind that as an S-corp shareholder-employee, the IRS expects your salary to meet Reasonable Compensation standards. Failure to do so can result in even more complex issues down the line.
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