Setting a Reasonable Salary

Recommendations for Small Business Owners on Setting a Reasonable Salary

Tax Savings Opportunities

There are four federal taxation methods: Sole Proprietorship, Partnership, C-Corp, and S-Corp. An LLC may be taxed under any of the four methods. A Corporation, taxed as a C-Corp by default, may elect to be taxed as an S-Corp. Kentucky fully recognizes S-Corp and C-Corp elections and taxes such entities in accordance with IRS regulations. See KRS 141.050(1).

When taxed as a Sole Proprietorship or Partnership, all income received is allocated to the business owners based on their ownership percentages (a sole proprietor receives 100% of the business income by definition). The business owners may not avoid taxes by keeping some business income within the business (rather than distributing it to owners) and cannot distinguish between profit distributions and salary. The business owners must pay personal income taxes and payroll taxes on the entire figure distributed to them.

When taxed as either a C-Corp or S-Corp, the business owners have the opportunity to allocate a portion of the income as business profits/dividends and pay a separate amount as salary/wages to the business owners. Because of the different tax rates for individual income, corporate income, and payroll taxes, there are opportunities for small business owners to achieve significant tax savings through such allocations. A business should carefully discuss these tax methods, how/which individual owners will receive business profits and losses, and specific salary figures with an accountant knowledgeable with the business’ specific financial picture.

Relevant Tax Laws

Employment/Payroll Taxes (2010)

  • Taxed 12.4% on the first $106,800 of gross earnings for Social Security
  • Taxed 2.9% on all gross earnings for Medicare
  • The employer pays half and the employee pays half (through the employer’s withholding). Kentucky, like most states, does not impose additional employment taxes.
  • See 26 USC 3101-3128.

Corporate Income Taxes (2010)

  • Taxed 15% on the first $50,000 of corporate income
  • Taxed 25% of income above $50,000 and through $75,000 of corporate income
  • Taxed 34% of income above $75,000 and through $100,000 of corporate income
  • Kentucky, like most states, imposes additional corporate income taxes. In Kentucky, an additional 4% tax is added on the first $50,000 of corporate income and an additional 5% on income above $50,000 and through $100,000.
  • See 26 USC 11(b)(1) and KRS 141.040(6).

Tax Methods

C-Corp Taxation
A business taxed as a C-Corp is subject to “double taxation”: the business income is taxed to the business at the corporate income tax rate while profits distributed to its owners are taxed to the individual owners at the individual income tax rate. The C-Corp must also pay its owners a reasonable salary, which is taxable to the individual owners at the individual income tax rate and is also subject to payroll taxes.

A C-Corp business may deduct salaries paid on its corporate income tax return, thereby reducing the amount of corporate income tax owed. Though its owners will have to pay payroll taxes on this figure, total payroll tax paid is usually much less than that paid as corporate income tax. Therefore, to reduce its overall tax burden spread across the business and its owners, a C-Corp has an incentive to pay its owners more in salary and less as profit distributions.

S-Corp Taxation
A business taxed as an S-Corp receives “pass-through taxation”: the business is not taxed at the entity level but rather each owner is taxed at the individual income tax rate on his or her respective ownership percentage of the business income. The S-Corp must also pay its owners a reasonable salary, which is taxable to the individual owners at the individual income tax rate and is also subject to payroll taxes.

Since an S-Corp business pays no entity-level taxes, there is no opportunity to achieve a deduction by classifying monies paid to owners as salary rather than profits. Therefore, to reduce the tax burden on its owners (by cutting payroll taxes), an S-Corp has an incentive to pay its owners less in salary and more as profit distributions.

Importance of Setting a Reasonable Salary

The IRS recognizes these incentives and requires business owners to pay themselves a “reasonable” salary. It will closely scrutinize the salary paid to C-Corp shareholders to see if it is excessive and monitor the distributions made to S-Corp owners to see if it is deficient. In general, the IRS expects compensation paid as salary to reflect the services that the owner-employee personally provides to the business.

The IRS will audit businesses which appear to pay unreasonable salaries, thoroughly examining the business’ gross receipts, claimed deductions, and the services provided by each employee. If it appears to the IRS that the salary is not “reasonable” in such a way that unfairly reduces the business’ tax payments, the IRS has the ability to reclassify income as it sees fit. IRS – S Corporation Compensation and Medical Insurance Issues. If income is reclassified, back taxes will be assessed, deductions will be disallowed, and interest and penalties will be owed.

General Guidelines for Setting a Reasonable Salary

To avoid an audit and reclassification, a business should set the salaries of its owner-employees in keeping with the following general guidelines:

  1. Salaries should be based on the value of the services rendered to the business, which takes into account (i) the number of hours worked; (ii) the position and its duties and responsibilities; (iii) the individual’s knowledge, skills, and abilities; and (iv) the salary paid to employees performing similar tasks who are not also owners.
  2. Even if/when the business is losing money, some minimum amount of wages should be paid (S-Corp concern). A business may be able to avoid or set very low wages during its startup stage but cannot overcome the presumption that a person will eventually stop working for free/very low wages.
  3. Even if/when the business is earning substantial profits, some large amount of wages will be considered excessive (C-Corp concern). Though corporate executives can be paid high salaries, very large salaries appear inflated to achieve a corporate income tax deduction.
  4. Consider prevailing market salary figures for the same or a comparable position. Review Salary.com, PayScale.com, or the Bureau of Labor Statistics for industry standards. A business should set a salary close to such figures, which demonstrates a likelihood that a non-owner would be willing to accept the same job at the particular salary offered.
  5. Set salaries as far in advance as possible, so it does not appear to be an arbitrary figure derived after careful calculation to achieve maximum tax savings. Along the same lines, the IRS will closely scrutinize year-end bonuses paid (taxed as salary), which may be a cover for tax manipulation.
  6. Discuss any specific concerns with an accountant, who can suggest reasons and documentation that could substantiate the chosen salary figures, should they be audited.