If you are considering an S Corp, you’ve come across this term and are probably asking, “What’s reasonable compensation?” Fair question–and we’re glad you asked! Reasonable compensation is simply the amount that you pay yourself in an S Corp as your annual salary. In the world of S Corps, coming up with this number is important because, well, the Internal Revenue Service needs to know it, and it is a big determining factor in how much tax you pay!
The IRS requires that all S Corp owners or shareholders take a reasonable salary based on two things: 1) the relevant industry averages (i.e. what would you be paid for your services as a W2 employee on the open job market) and, 2) the net income of your business. Based on those criteria, reasonable compensation can be a bit of an ever-moving target. What is “reasonable” anyway, right?
Luckily, enough precedent and case studies exist to add some objectivity. On top of that, Lettuce leverages vast industry experience to help determine the precise salary for you to take, including analysis of such variables as: your business’ net income, the amount of tax-free income distributed (more about that later), and your estimated personal tax liability.
Let’s say you net $200k in total annual income. While certain industries require more or less, a good general rule says no less than 40% of your net income be taken as salary. Forty percent of $200k puts your salary at $80K. You’d then pay payroll taxes (Social Security and Medicare) on $80k, not on the full $200k. The $80k you take as your salary becomes tax deductible for your business and, since you’re also the employer, your business can take that deduction.
Next, we look at the remainder of your net income. In our example, since we’ve allocated 40% to salary, that leaves us 60% of $200k (i.e. $120k). This remaining amount is the amount of income you take from the business and is known as the owner’s distribution, and isn’t subject to the same level of taxes as your salary.
We’ve established that your annual net income is divided into two parts: Salary and Owner’s Distribution, the latter being the amount of income you’re allowed to take free of Social Security and Medicare taxes (though still subject to federal and state taxes). In order to remain S Corp compliant, we make sure the right balance exists between the owner’s distribution and the amount you take in salary.
These might include any W2 income, the income from a spouse, investment gains or losses, inheritance, or any number of life events–all of which can impact your overall tax picture. Careful analysis of your personal tax return can play a vital role in helping us calculate your ideal business compensation and make sure you aren’t paying more than your fair share.
This proven approach to calculating your reasonable compensation works thanks to our sophisticated finance and accounting system, along with our in-depth knowledge of S Corp rules and regulations. With Lettuce, you can expertly navigate the reasonable compensation journey and maximize your tax savings benefits.