The owner-operator of an entity taxed as an S-corporation typically wants to minimize the required amount of taxes to be paid which can be managed by paying a lower wage to the owner-operator thereby reducing payroll taxes to be paid. This pertains to a concept in the tax laws called reasonable compensation. In short, the tax laws require that an entity taxed as an S-corporation must pay reasonable compensation to owner-employees who
provide services to the entity taxed as an S-corporation.
The owner of an S-corporation is allowed to receive a combination of wages and shareholder distributions as compensation. The advantage of being taxed as an S-corporation is that the company and employee will not be paying payroll taxes on the portion taken out as shareholder distributions. The amount that is allowed to be received by the shareholder as distributions depends on what reasonable compensation is determined to be.
Reasonable compensation can be defined as “what would you pay someone if you were to hire somebody to do the job of the owner-employee?” To determine reasonable compensation, it is common to go to Internet resources such as salary.com or bls.gov. On those websites, you can search for job functions similar to the owner employee jobs. Or you may use whatever is the closest available. Local recruiters may provide another reference point. The search results will provide an upper and lower end of a range.
It is in the S-corporation owner’s best interest to pick the lower end of the range when picking reasonable compensation as that maximizes the distributions paid. When you have done the research and documented it, circumstances of the business become factors e.g. can the business sustain paying reasonable compensation with its current cash flow.
If you have not done the research and until you do, a 50-50 split between distributions and wages may be used as a temporary guideline. However, I recommend that you do the research and document it and subsequently pay reasonable compensation within weeks, not months.
Please note that the reasonable compensation paid with withholding of federal and state income taxes have a direct relationship with quarterly estimated income tax payment
requirements. That is, everything being equal, paying lower wages with corresponding withholding will require higher quarterly estimated income tax
payments due every year on April 15, June 15, Sep 15 and January 15 (following year, 1/15/11 for tax year 2010).
The above is an excerpt from our free ebook.