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I am the owner and sole member of a small s-corp. I am a litte confused regarding the reasonable salary the IRS requires.

The S-Corp is fairly small and requires very little work to maintain.

Would I be subject to an audit for the following:

S-Corp makes a profit of $25k for the year I pay myself $20k in salary and $5k in distributions

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    "Would I be subject to an audit for..." is a poor question - audit rules are generally not public, and they do change. You don't want to structure something in order to prevent an audit. If you are concerned that you may be accidentally not following any specific tax rules, your goal should always be "what is acceptable", not "what gets picked up on audit". – Grade 'Eh' Bacon Jul 21 '16 at 14:05
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The answer depends on this: If you had to hire someone to do what you are doing in the S-corp, what would you pay them?

If you are doing semi-unskilled work part-time, then $20k might be reasonable. If you are a professional working full time, it's too low. Don't forget that, in addition to "billable" work, you are also doing office tasks, such as invoicing and bookkeeping, that the IRS will also want to see you getting paid for.

There was an important court ruling on this subject recently: Watson v. Commissioner. Watson owned an S-Corp where he was the sole employee. The S-Corp itself was a 25% owner in a very successful accounting firm that Watson worked through. All of the revenue that Watson generated at the accounting firm was paid to the S-Corp, which then paid Watson through salary and distributions. Watson was paying himself $24k a year in salary and taking over $175k a year in distributions. For comparison, even first-year accountants at the firm were making more than $24k a year in salary. The IRS determined that this salary amount was too low. To determine an appropriate amount for Watson's salary, the IRS did a study of the salaries of peers in firms of the same size as the firm Watson was working with, taking into account that owners of firms earn a higher salary than non-owners. The number that the IRS arrived at was $93k. Watson was allowed to take the rest ($80k+ each year) as distributions.

Again, this number was based on a study of the salaries of peers. It was far short of the $200k+ that the S-Corp was pulling in from the accounting firm. Clearly, Watson was paying himself far too low of a salary. But even at this extreme example, where Watson's S-Corp was directly getting all of its revenue from one accounting firm in which Watson was an owner, the IRS still did not conclude that all of the revenue should have been salary and subject to payroll taxes.

You should ask an accountant or attorney for advice. They can help you determine an appropriate amount for your salary. Don't be afraid of an audit, but make sure that you can defend your choices if you do get audited. If your choices are based on professional advice, that will help your case.

See these articles for more information:

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    @littleadv I do not disagree with the law, the courts, or the articles I have linked to. I disagree with your summary of what is in them. I am reading them, and I believe that they support my answer. Others can read both of our answers and the sources cited, and decide for themselves. I do agree with you that the discussion seems to be pointless. – Ben Miller Dec 12 '14 at 3:14
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Generally if you're a sole S-Corp employee - it is hard to explain how the S-Corp earned more money than your work is worth. So it is reasonable that all the S-Corp profits would be pouring into your salary. Especially when the amounts are below the FICA SS limits when separating salary and distributions are a clear sign of FICA tax evasion. So while it is hard to say if you're going to be subject to audit, my bet is that if you are - the IRS will claim that you underpaid yourself.

One of the more recent cases dealing with this issue is Watson v Commissioner. In this case, Watson (through his S-Corp which he solely owned) received distributions from a company in the amounts of ~400K. He drew 24K as salary, and the rest as distributions. The IRS forced re-characterizing distributions into salary up to 93K (the then-SS portion of the FICA limit), and the courts affirmed.

Worth noting, that Watson didn't do all the work himself, and that was the reason that some of the income was allowed to be considered distribution. That wouldn't hold in a case where the sole shareholder was the only revenue producer, and that is exactly my point.


I feel that it is important to add another paragraph about Nolo, newspaper articles, and charlatans on the Internet. YOU CANNOT RELY ON THEM. You cannot defend your position against IRS by saying "But the article on Nolo said I can not pay SE taxes on my earnings!", you cannot say "Some guy called littleadv lost an argument with some other guy called Ben Miller because Ben Miller was saying what everyone wants to hear", and you can definitely not say "But I don't want to pay taxes!".

There's law, there are legal precedents. When some guy on the Internet tells you exactly what you want to hear - beware. Many times when it is too good to be true - it is in fact not true. Many these articles are written by people who are interested in clients/business. By the time you get to them - you're already in deep trouble and will pay them to fix it. They don't care that their own "advice" got you into that trouble, because it is always written in generic enough terms that they can say "Oh, but it doesn't apply to your specific situation".

That's the main problem with these free advice - they are worth exactly what you paid for them. When you actually pay your CPA/Attorney - they'll have to take responsibility over their advice. Then suddenly they become cautious. Suddenly they start mentioning precedents and rulings telling you to not do things. Or not, and try and play the audit roulette, but these types are long gone when you get caught.

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    I disagree slightly. Businesses, even S-corps, are allowed to make a profit, and in the S-corp, profit is paid out as dividend. The reasonable salary is not dependent on how much the business makes, but instead is based on what the market rate is for labor. – Ben Miller Sep 10 '14 at 20:10
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    Nolo has written an article on this subject. In it, they say that the pay compared to income of the business is just one factor of many in determining what is reasonable. For the two examples in the article, in neither of them did the IRS conclude that all income should have been salary. – Ben Miller Sep 10 '14 at 23:04
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    Nolo is not as authoritative as the IRS, perhaps, but the article is written by a tax attorney and does reference actual IRS cases. I wouldn't call it "random people writing stuff on the internet," unlike you or me. In the end, however, my advice does boil down to "ask an accountant or attorney for advice," so on that we agree. – Ben Miller Sep 11 '14 at 0:43
  • As I said before, @BenMiller can disagree all he wants, but unless he's a Supreme Court Justice - his dissent is irrelevant. This is the position of the US Federal Court, so if you want to argue against it - don't do it on Money@SE - go to SCOTUS. If you don't - don't "disagree", its useless. – littleadv Dec 12 '14 at 2:11
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You can get audited for anything

Business owners are more likely to get audited than people filing 1040-EZ's for their simplistic income tax obligation. According to HR Block

I hope you enjoy the process where you explain the source of your earnings

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    I'm not too clear how this actually answers the question - could you relate it more specifically to the OP's situation? – Ganesh Sittampalam Sep 10 '14 at 7:36
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    @CQM - You answered 'Would I be subject to an audit', I think the DVs were expecting an answer to 'Reasonable Salary.' – JoeTaxpayer Sep 10 '14 at 11:02
  • @GaneshSittampalam the question was "Would I be subject to an audit" the answer is yes. Anything else is a complete misunderstanding for how that works, doesn't matter that it isn't the answer that OP wants to hear. OP will need to ask a different question. – CQM Sep 10 '14 at 12:43
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    @CQM: You've said that being a businessman increases the odds of an audit. I believe the intended question was whether a proposed salary/distribution would FAIL an audit. Note the headline. (I also disagree with the tone of your last line; in my experience the IRS is not the boogeyman people like to claim. They saved me $11K the one time they audited me, and that is not an uncommon occurrence. If you aren't pushing the boundaries, an audit is not much more than annoying.) – keshlam Sep 10 '14 at 13:06
  • @keshlam I don't disagree with you about audits. I didn't make an opinion about that – CQM Sep 10 '14 at 13:32

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