S Corporations and the Reasonable Compensation Payroll Requirement
Many small business owners and entrepreneurs that use Schedule C to report their business income are unaware of the benefits of creating an LLC and filing an S Corp election. Schedule C income is subject to self-employment tax, which is equal to the employer and employee portions of social security and medicare tax-15.3%! S Corporations (S Corps) are corporations of which the earnings are taxed to the owners, regardless of when the profits are distributed to the owner. While this might not seem like an advantage to you, perhaps the fact that S Corp earnings are NOT subject to social security and medicare tax sounds more like an advantage to you. To help put this in perspective, $50,000 of Schedule C profit is subject to $7,650 of self-employment tax ON TOP of income tax. The same $50,000 profit of an S Corp is subject to $0 self-employment tax.
If this seems too good to be true without a catch, you are on your way to understanding the logic at work in the IRS. In order to fill the coffers of the social security and medicare trust funds, the IRS requires S Corp owners to issue a W-2 and pay social security and medicare tax on those wages. But what is the wage requirement? How much S Corp profit should you reclassify as W-2 wages to avoid IRS scrutiny? The IRS doesn't give much concrete guidance on what that number should be. Instead, the IRS gives us the vague platitude 'reasonable compensation'.
The IRS doesn't give us a lot of guidance on what 'reasonable compensation' is. The best definition we have is from a series of court cases and can be summarized as follows: reasonable compensation is the amount which an S Corp owner would be paid by a 3rd party to perform the services performed for the S Corp. In other words, reasonable compensation is what you would be paid by someone else to do the same work you do for your business.
There are many different things to consider when calculating this number that are beyond the scope of this article. If anything in this article triggers concern in any way and you want to learn more, be sure to check out our next article in this series where we will discuss some calculations that can help us determine a reasonable number to report as wages in order to prevent an IRS audit. If you're an S Corp owner, I strongly encourage you to schedule some time with us to go over what is your reasonable compensation number.