If you have a profitable S-Corporation (S-Corp), it’s worth taking a moment to remind you about reasonable S-Corp wages… before the State of Florida does!
How S-Corp payroll works
S-Corporations are unique because they provide the limited liability of a corporation and the pass-through taxation of a partnership. In an S-Corp, you typically pay yourself through a mix of salary as an employee and distributions as a shareholder.
Profits and losses in an S-Corp pass through to the shareholders. Unlike LLCs, S-Corp shareholders can receive a “reasonable” salary, which is subject to employment taxes. Any additional distributions are considered dividends and taxed at a lower rate. The main tax benefit of an S-Corp is reducing self-employment taxes, particularly Social Security and Medicare taxes (payroll taxes).
One of the most challenging aspects of running an S-Corp is determining what constitutes a reasonable salary and officer compensation. You also need to ensure that you’re paying payroll taxes appropriately and not avoiding Federal Insurance Contributions Act (FICA) taxes.
You may also be interested in: How to convert an LLC to an S-Corporation
What the law says about a reasonable wage for an S-Corp in Florida
Florida law states that before taking distributions of income from an S-Corporation, officers of the company must take a reasonable wage. Federal law is even more stringent because the government collects Social Security and Medicare taxes—which S-Corp income is not subject to, but salary compensation is.
We recommend reviewing your specific situation with a tax expert to determine a reasonable wage for the work you do. The last thing you want is to get into hot water with the IRS or Florida Department of Revenue. If the IRS determines that you haven’t been paying yourself a reasonable salary, your non-qualified distributions could be reclassified as income and could be subject to employment taxes, interest, penalties, and fees.
How will Florida know if you are taking a reasonable S-Corp wage?
Florida does not generally require S-Corporations to file tax returns with the state, and there is no state income tax. However, the state will closely review your sales tax returns. If you file for a sales tax certificate, they will check to see if you have filed for an Unemployment Tax ID. If you’re generating a lot of sales taxes, the state will see what you’re reporting for wages. Not reporting wages (or under-reporting wages) is a common red flag for a payroll audit.
What is “reasonable”?
Sure, the IRS uses the word reasonable, but they also find it tricky to define precisely what is reasonable and what is not. It therefore makes sense to work the other way around—figure out a reasonable wage by ensuring it doesn’t seem unreasonable. While it can be hard to define what is reasonable, we can more confidently define what is unreasonable. For example:
- Trying to reduce your overall income taxes by taking most of your income in distributions while paying yourself an artificially low salary is unreasonable.
- Paying yourself a salary that is significantly below the market rate for your role and responsibilities is unreasonable.
- Claiming minimal or no salary while the business generates substantial profits is unreasonable.
How can you determine a reasonable salary?
There are no set standards for what constitutes a reasonable salary; it’s a facts and circumstances test that varies for each person. Factors to consider include total business profit, your location, and the salary for similar positions, though no single factor is determinative. To establish a reasonable salary, research what similar roles in your industry and geographical area are paid and ensure your salary reflects what you would pay an unrelated third party for the same services.
How to make strategic use of S-Corp distributions
To benefit from an S-Corp’s tax advantages, it’s important to balance your salary and distributions. Gradually increase your salary over time (similar to how large companies give annual raises), based on a documented performance review. You can also take distributions on top of your salary, and they don’t need to be consistent in timing or amount. You’ll still pay income tax on your distributions, but they’re exempt from payroll tax.
If you would like to discuss your S-Corp’s payroll, or whether it’s time to convert your LLC to an S-Corp, please reach out. We would love to help guide you through your unique situation with a comprehensive review of your tax situation.
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