Once a startup business is formed and starts generating a profit, owners are faced with the decision of how to begin withdrawing money from the business. Owners that decide to start drawing a salary are faced with an often-controversial issue of determining how much to pay themselves. According to Payscale’s data collected from 2019, American small business owners paid themselves an average annual salary of $66,737. A whopping 83%of small business owners took an annual salary of less than $100,000, and 30% report taking no salary at all. Nevertheless, with such a wide range of possible “reasonable” salaries and lack of any bright-line rules, determining a “reasonable” salary can be complicated. This post is intended to answer a few commonly asked questions about small business owner compensation.
Am I Required to Pay Myself a Salary?
The short answer is: No. If your business earns little to no income, or incurs a loss, the IRS does not require a business to pay its owner a minimum salary.
However, for business entities classified for tax purposes as “S” corporations, owners who are actively involved in the business need to be especially careful in deciding whether or not to take a salary. In the small business community, electing “S” corporation status is, first and foremost, a payroll tax-saving strategy. Why? Because as an “S” corporation, an owner’s salary is subject to payroll taxes (e.g., Social Security, Medicare), but “S” corporation profit distributions (also referred to as dividends) are not subject to those payroll taxes. Therefore, if an “S” corporation owner decides to forego a salary and only collect distributions, he would necessarily save a lot of money in payroll taxes. For obvious reasons, the IRS frowns on such tax avoidance efforts, and over the past 20 years, the IRS has become increasingly aggressive in cracking down on such tax avoidance strategies by auditing thousands of “S” corporations with owners that do not collect a salary.
If the IRS determines that an “S” corporation owner is intentionally attempting to evade payroll taxes by not taking a salary and just taking money out of the business in the form of profit distributions, then the IRS could reclassify all or a portion of those distributions as salary and require payment of employment taxes PLUS penalties of up to 100% of the payroll tax and additional negligence penalties. The IRS has made it increasingly clear that it will pursue significant penalties when it concludes that a business owner took an unreasonably low salary, or no salary at all, for services rendered in an attempt to evade taxes. Therefore, it would be wise to consult your accountant and business attorney to determine if you should be taking a salary, even if it seems insignificant.
If I Raise Capital From Outside Investors to Grow the Business, How Do I Determine My Salary?
Determining a founding owner’s salary can be a sensitive issue when the business starts relying on someone else’s money. To successfully navigate this process, a startup founder should:
- Determine what her necessary monthly expenses are;
- Build in a little bit of cushion for rainy days;
- Plan on keeping those monthly expenses to a minimum; and
- Resist the temptation to be greedy.
In an ideal world, instead of surprising investors, a founder would present her preferred salary as an expected expense in the company’s business plan/teaser during meetings with potential investors. In this case, an owner should be able to explain in clear and convincing language that her expected salary is reasonable considering all relevant facts and circumstances, including the unique value of her services to the company. A founder should be prepared to prove her worth and follow the “keep it simple” principle in such evaluations. However, for those who may have already raised capital from outside investors and are now engaged in salary negotiations, it will still be helpful to follow the same steps, while also seeking input from their accountants and business attorneys.
What is Considered a Reasonable Salary for IRS Purposes (in the context of an “S” corporation)?
There is no set formula or bright-line rule defining how much business owners should pay themselves. The best guidance that the IRS offers is contained in the instructions to Form 1120S, U.S. Income Tax Return for an S corporation, that provides, in relevant part, “[d]istributions and other payments by an “S” corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” Essentially, the IRS is suggesting that a reasonable salary is one that is reasonable and appropriate.
Given the circular guidance and lack of a formula to scientifically determine a reasonable salary, courts have based their determinations on a case-by-case basis. Through this process, courts have cited the following factors, among others, in making “reasonable salary” determinations:
- Training and experience;
- Duties and responsibilities;
- Time and effort devoted to the business;
- Dividend history;
- Payments to non-shareholder employees;
- Timing and manner of paying bonuses to key people;
- What comparable businesses pay for similar services;
- Compensation agreements; and
- The use of a formula to determine compensation.
Based on the foregoing, it seems clear that the courts do not consider what a business owner believes is “reasonable” to be neither dispositive, nor even relevant. Similarly, the IRS does not appear to take an owner’s subjective belief into consideration.
A general rule of thumb is that a reasonable salary should be comparable to what you would pay an employee, equivalent to yourself in all relevant ways, for the work you are doing for the business or what you would be paid for the same job by a third-party employer of a similar size and market position. Further, in the event of an audit, business owners should always be able to support the salary that they are paying themselves.
Setting a reasonable salary for yourself that will withstand IRS scrutiny is something that you should discuss with your accountant because it is principally a tax and accounting issue. But, for additional information or assistance with your small business transaction or compliance questions, please e-mail or call Eric Perkins at [email protected] or (804) 205-5162.
By: Logan Childress