4 Critical Steps to Paying Yourself Reasonable Compensation

Are you a shareholder/employee of an S Corporation and not sure how much to pay yourself? This is a common problem and the stakes are high. Pay yourself too much and you’ll end up with a higher tax bill than necessary.  Pay yourself too little and the IRS can make your life miserable. This post will give you the guidance you need to sort this out.

Here are 4 steps to determining the right amount of compensation.

1. Realize that the compensation must be reasonable. The tax code does not provide a specific formula for calculating your wages or salary, but it does state clearly that you must be paid fair market value (FMV) for the work you do for the corporation. So obviously, if you are working for the business, you must be paid like any other employee (even if you are the only employee). Don’t even think about paying yourself zero wages (which some have tried to do and failed miserably; i.e. they got nailed by the IRS).

2. To determine FMV of your services, find out what others are being paid to do the same kind of work that you do. This isn’t rocket science. Any number of websites provide current wage and salary information for every conceivable job on the planet. If you work full-time, the annual salary of others in your field is a great starting point for this determination.  If you work part-time, calculate the hourly rate based on the annual salary of comparable workers and then pay yourself that rate for the actual number of hours you work. It couldn’t be any easier that that, could it?

3. The corporation’s profit (before deducting your wages or salary) isn’t necessarily equal to your compensation. Just because your business has a $100,000 profit doesn’t mean your salary should be $100,000. Your compensation could be less than the profit, depending on the nature of the work you do and/or the amount of time you actually spend on the job. Again, FMV of services rendered should be the main consideration.

4. Don’t forget that any profit remaining after deducting your compensation will legally avoid payroll taxes. This is one of the best built-in tax saving characteristics of the S Corporation. It is what it is. The amount of any payroll tax savings should not be driving your compensation calculation. Rather, you calculate the FMV of your services and then reap the benefits when compensation happens to be less than profits.

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2 Responses to 4 Critical Steps to Paying Yourself Reasonable Compensation

  1. Tom Luker says:

    Wayne, great advice in this #2. One way to improve on the “reasonable wage” factor & do it in a tax-free way, is to have a properly written Sec. 105 Medical Expense Reimbursement Plan. Even though the benefits move over to the Form 1040 as an ordinary income dividend, the insurance premium can be used as a SE premium deduction above the line. The MERP adds to the wage package without taxation, except for a business tax deduction. We’ve helped defend a client’s IRS audit in that very way and merely provided the paper work back-up of the MERP we administered for a one-person S-Corp a few years back. Good talking with you recently and I always look forward to helping anyone at 888-TLC-PLAN.

    • Wayne Davies says:

      Thanks for the comment, Tom. The Sec 105 Medical Expense Reimbursement Plan is a great tax-saving strategy. Glad to see you continue to help folks implement that.

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