S-Corp Salary 50/50 Rule: Simple Guide [+ IRS Red Flags] (2024)

Most people understand why S-Corporations are the number one entity structure. You can save on employment taxes by taking a wage less than the company’s profit. But how do you determine that wage? Many people use the S-Corp salary 50/50 rule.

We understand that limiting your payroll taxes is very important. However, you need to make sure that you stay IRS-compliant.

How Does the S Corp 50/50 Rule Work?

The business profit is evenly divided (50/50) between owner salary and profit distribution. For example, if an S Corp owner makes $100,000 annually, the W2 salary would be $50,000 and the profit distribution would be $50,000.

This article will examine the S-Corp salary 50-50 rule and discuss a few myths. The goal is to give you a framework for calculating a reasonable wage for work that you perform for an S corporation. Let’s jump in!

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What is an S-Corporation?

An S corporation is one of the most utilized business entities for small business owners. They work great if you have consistent income, few owners, and desire pass-through taxation.

An S corporation does not pay tax itself. The taxes are merely pass through to the owners and included on their individual tax returns. For this reason, it is called a pass-through entity, and tax is very similar to a partnership.

But unlike a partnership, owners must pay themselves a reasonable wage for their work. The IRS has designated reasonable compensation rules for companies to follow. The salary itself is subject to employment taxes. However, any profits flowing through the owners are taxed as investors and not subject to employment taxes.

An S corporation does not have dividends, per se. It has distributions that are the resulting profit of the company. The owner is taxed on profits, regardless of whether they receive any distributions from the business.

In addition to a reasonable salary, S-corp owners can also take an owner’s draw. An owner’s draw is a distribution of profits that a business owner takes from the company.

What is the S-Corp Salary 50/50 Rule?

The S-Corp Salary 50/50 Rule, sometimes as the S-Corp Reasonable Compensation Rule, is a guideline used to determine the reasonable compensation that should be paid to an S-Corp owner-employee. Under this rule, it is recommended that an S-Corp owner-employee should pay themselves a salary that is reasonable for the services they provide to the business and then take any additional profits as a distribution. This results in payroll tax savings.

The rule derives from the fact that S-Corporation owners can take both a salary and a distribution of profits from the company. However, if the owner takes an unreasonably low salary to minimize payroll taxes, the IRS may reclassify some of the distribution as salary and impose additional payroll taxes.

The 50/50 Rule is not a hard and fast rule but rather a guideline. It suggests that approximately 50% of the company’s profits should be paid out as a salary to the owner-employee, while the remaining 50% can be taken as a distribution. This guideline considers that the owner-employee is providing both labor and capital to the business.

It’s important to note that the 50/50 Rule is just a guideline. The actual ratio of salary to distribution may vary depending on many factors, such as the industry, the owner’s experience and qualifications, and the specific services provided to the business. S-Corp owners must consult with a tax professional to determine reasonable compensation for their situation and avoid any potential IRS scrutiny.

Determining a Reasonable Salary for S Corp Owners

Determining a reasonable salary for S corp owners can be a complex process. The determination depends on various issues, including industry standards, company revenue and profits, time and effort, and other compensation.

The IRS guides reasonable compensation for S corp owners in the form of Revenue Ruling 59-221. This ruling states that the reasonable compensation for an S corp owner is the amount that would be paid to an unrelated party for similar services.

The ruling also states that the following factors should be considered when determining reasonable compensation:

1. The employee’s role in the company
2. The employee’s responsibilities
3. The employee’s time and effort
4. The employee’s qualifications
5. The employee’s experience
6. The complexity of the company’s business operations
7. The company’s financial condition

It is important to note that there is no specific formula or percentage for determining a reasonable salary for S corp owners. The determination must be based on the individual circ*mstances of the business and the owner’s contributions to the company.

Potential Tax Savings

If S corp owners can take a portion of their income as a distribution rather than as salary, they can save on self-employment tax. The distribution is not subject to self-employment tax so long as it is not over the owner

As a small business owner, it is vital to understand the different tax implications of your business structure. Understanding self-employment tax is crucial for those who own an S corporation (S corp). In this article, we will define what S corp self-employment tax is and how it differs from other types of taxes.

Final thoughts

In summary, the IRS’s reasonable compensation rules for S-Corp owner-employees are designed to ensure that they are paying themselves a reasonable salary based on the services they provide to the business. This helps to prevent S-Corp owners from taking excessive distributions to avoid payroll taxes while still allowing them to benefit from the tax advantages of the S-Corp structure.

S-Corp owners need to consult with a tax professional to determine the appropriate level of reasonable compensation for their particular situation. By doing so, they can avoid potential IRS scrutiny and ensure that they follow the rules while maximizing the tax benefits of their S-Corp. Failure to follow reasonable compensation rules could result in penalties and additional taxes, so it’s essential to take this issue seriously and seek professional advice.