How to Determine “Reasonable Salary” in an S-corporation

If you own a dental or medical practice taxed as an S-corporation, then the IRS has sent you a notice CP261 with language that reads something like this:

“You must determine a reasonable salary when a shareholder-employee of an S corporation provides services to the corporation. Payments to a shareholder-employee for services provided to an S corporation are wages and are subject to employment taxes. We may re-characterize distributions paid to a shareholder as salary if the distribution was paid in lieu of reasonable compensation.”1

In every practice where the dentist is both an owner and seeing patients, there are two types of compensation. First, as an employee working on patients you should be paid a salary or wage for your hours worked. Second, as a business owner you should be entitled to distributions to pay the taxes that flow to your personal income tax return, pay for debt services, receive a return on capital invested in the business, and for time spent growing the business as an entrepreneur.

Owners have a lot of control over what salary or distributions they pay themselves, especially when there is only one shareholder in the S-corporation. The main difference between a salary and a distribution is salaries are subject to Federal and State payroll taxes, and distributions are not. A quick refresher on what the Federal payroll taxes include:

  • Social Security – 12.4% on income up to $118,500 for 2015 (adjusted annually), paid half by the employer, half by the employee
  • Medicare – 2.9% on all income, paid half by the employer, half by the employee
  • Additional Medicare – 0.9% on income over $200,000 for single or over $250,000 for married filing jointly taxpayers, paid entirely by the employee

As an owner of an S-corporation, you would prefer to have all your income paid through distributions, but the IRS would prefer it to all be wages to collect as much payroll tax as possible. And as they state in their initial letter approving the S-election, they can and will reclassify your distributions as a salary.

The reverse dichotomy exists in C-corporations. If a shareholder-employee takes out a wage, he or she must pay the payroll tax on it similar to an S-corporation. However, distributions get taxed as dividends from C-corporations at a rate up to 23.8%, so the IRS takes a reverse position on what is a reasonable salary in a C-corporation compared to an S-corporation. This fact is important, because reasonable should be reasonable regardless of whether a business is an S- or C-corporation, so we can use the IRS’s C-corporation reasoning against itself when deciding S-corporation salary.2, 3

It’s worth pausing to mention here that a surprising number of dental and medical professionals still operate as a C-corporation instead of an S-corporation, and take all the profits out of the business at the end of the year through a salary bonus. This results in significantly more payroll tax paid compared to an identical practice running as an S-corporation where profits can be distributed without incurring payroll tax. Furthermore, if you incorrectly estimate the year-end bonus, you’ll either incur and additional 35% tax on the C-corporation’s profits left in the practice or generate an NOL which postpones the deduction to later tax years. We highly recommend consulting with a tax advisor to determine if making an S-election would benefit you – the annual tax savings can be significant.

Five Tests to Determine Reasonable Salary

The answer about what is reasonable is different for every taxpayer and it may change each year. There is no one-size-fits all answer, no percentage of net income, no salary-to-distribution ratio, and no threshold such as the social security wage cap to determine what is reasonable. Instead we look to the court cases involving taxpayers and the IRS battling over whether a specific circumstance was reasonable or not.

From various court cases4, a multi-factor approach has developed and been adopted by the various US court systems to determine reasonable salary. There are many factors the courts considered, and the top five are summarized below.

  1. Employee qualifications and role in the company

    What are your years of experience, education, training, and position in the business? As the years go on and you’re working longer hours with more experience you should consider raising your own salary. Or if you bring on an associate and scale back your hours you should consider reducing your salary.
  1. How well the business is doing

    Did your company have a bad year? One of the risks of running a business is that there are years of loss when it cannot even afford to pay its employees, and it’s usually the owner who cuts his or her own salary to solve a temporary cash crunch in the business. It is reasonable to adjust your own salary based on the performance of the business.

    The courts also consider the prevailing economic conditions your business operates in. Was there an economic downturn or recession? Has your industry in general taken a hit? Was there a natural disaster in your area that affected your business? 
  1. Prevailing rates of compensation and external comparison to other businesses

    How does your salary stack up against your peers? How much would it cost someone else to hire you at a similar practice in your area? How much would you pay to bring on someone with your exact same experience and skill?
  1. Salary policy of the taxpayer compared to all employees

    Is there internal consistency in how you and your employees are compensated within the business? Where does your salary stack up in the business? A good reality check is if you’re paying a brand new associate with less experience and skill more than you’re paying yourself for the same hours of work, your salary is probably too low.
  1. Hypothetical independent investor

    Frequently when dentists or medical professionals sell their practice, the purchase agreement requires you to stay on for one or two years. What would your salary be for those years when you can no longer take distributions from the business? What would be the lowest pay you would be willing to work for at that point? Your current salary should be near that number.

No one of these tests is decisive, so you should thoughtfully consider each one when determining where to put your own salary in your S-corporation.

The Bottom Line

The hazards of paying too much or too little salary are clear. On the one hand you could be needlessly paying payroll taxes on income you could take as an S-corporation distribution. On the other hand you could receive a nasty letter from the IRS stating that they are assessing additional tax, underpayment penalties, and interest on payroll taxes you missed from having too low of a salary. While there is no perfect formula to determine what a reasonable salary is, you should carefully consider the questions above. Talk with your tax advisor to determine if your salary is considered reasonable.

IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Footnotes

1 – See Revenue Ruling 74-44

2 – Applying reasoning used in court cases involving C-corporations to determine reasonable S-corporation salary is supported by a comment made by the Joint Committee on Taxation in a report issued in 2005 relating to S-corporations which states “In recent cases involving whether reasonable compensation was paid (not exclusively in the S corporation context), courts have applied a multi-factor test to determine reasonable compensation.” This indicates that the multi-factor approach can be relied upon to determine reasonable salary for both C- and S-corps.

3 – Hopefully it’s apparent that it’s generally much more tax efficient for businesses to operate as an S-corporation than a C-corporation. For a full article on which type of business structure works best for you, click here. (Link coming soon)

4 – Court cases include Mayson Manufacturing, Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949), and Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983), and Exacto Spring Corp., v. Commissioner, 196 F.3d 833 (7th Cir. 1999).

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