If you own an S Corporation and have not heard of the term, “Reasonable Compensation,” then I would suggest that you keep reading. You probably chose to make the S-Election with your LLC or Corporation so that you could take advantage of the self-employment tax savings afforded by an S Corp. As you may know, any income passed through to you on a K-1 from your S Corp is not subject to Self-Employment tax. Further, under the Tax Cuts & Jobs Act, that income is also eligible to be reduced by 20% (i.e. $100K taxed as if it were $80K) under Section 199A. Because of these tax advantages, the IRS mandates that you pay yourself a reasonable salary from the corporation (which is subject to payroll taxes and is not eligible for the 20% deduction).
What is “reasonable,” anyway?
In general, Reasonable Compensation is the market wage/salary that the corporation would need to pay someone to perform your job for the company. So, things like location, industry, market conditions, and the skill and scope of the services provided to the company all matter. Determining this figure is done by factoring in all of these variables. We can and do help clients in making this determination regularly.
What if I can’t pay myself?
Valid question…and one with a surprisingly reasonable answer. You actually don’t have to pay yourself in a given year so long as you don’t take distributions and the salary would have otherwise demonstrably jeopardized the financial health of the business. It stands to reason, after all, that you didn’t take those distributions because the business needed the cash.
Why am I complying with this rule again?
Failure to abide by the rules of Reasonable Compensation can result in your entity losing its S Corporation status all the way back to when the tax status was elected. This means that if you were an LLC originally, all of your income would be subject to Self-Employment tax which would create tax deficiencies in previous years along with associated penalties & interest. If you were a C Corporation originally, then all income would subject to double taxation. Sufficive to say, it would be the equivalent of someone slapping you in the face and drop-kicking your wallet into the Grand Canyon.
What do I do if haven’t paid myself through payroll or if I haven’t paid myself enough?
If this is the situation you find yourself in, please know that you’re not alone. We’ve inherited countless clients in these exact circumstances. The best game plan is to take corrective action immediately in order to seek the good graces of the IRS should you get audited. A good faith effort to get back into compliance isn’t an air-tight way to get out of trouble but it is your best game plan. This would include catching your salary up as much as possible from previous years’ deficits and seizing distributions until you do. Stuck on where to get started? Allow us to guide you back to the good graces of the IRS to potentially save you a grip of money and an excruciating migraine.
About Dark Horse CPAs
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