At the end of the year, many business owners look at their financial statements for ways to increase their compensation without hurting the business or getting into tax trouble. For companies organized as S Corps, the question often comes down to whether they should boost their take-home pay with a year-end S corp bonus or distribution.
S Corp bonus or distribution?
Typically, the answer is a distribution, but there are two requirements the shareholder must meet for this to make sense:
1. The owner must have taken reasonable compensation for the value of their services
Reasonable is a subjective term, but the IRS does give some guidelines to help establish reasonable compensation.
Essentially, the wages must be in line with the position the owner holds. For example, if the owner is a CEO, his wages must be based on what a CEO for that size company would earn. The same concept holds if a stockholder is a sales manager, CFO, operations manager, etc.
When establishing an S Corp owner’s salary, documentation helps. Look for compensation studies from trade associations or executive headhunters. These can provide some data on reasonable salaries. However, be sure you customize those estimates with company- and shareholder-specific factors, including:
Size and location of the business
The company’s compensation policy. Formally document the duties and responsibilities of all employees and compare the amounts competitors pay for similar jobs.
Employee qualifications, including education, professional training, reputation, industry know-how, and workload
Unfortunately, there is no one-size-fits-all approach to calculating the split between shareholder salary and distributions, but some common approaches include:
A 1:1 ratio between salary and distributions
A 60/40 split, allocating 60% to salaries and 40% to distributions
Setting salary at anything over the Social Security wage base ($132,900 for 2019)
Salary as 1/3 of the company’s taxable income
Any of these approaches can work. The right one depends on the company’s overall operating profits and what a reasonable salary is for the shareholder’s job.
2. The distribution should reflect the expectation of a normal return on the shareholder’s investment in the company
Before making a distribution, make sure the shareholder has enough basis to make a distribution. If the distribution exceeds the shareholder’s stock basis, the excess amount is taxable as a long-term capital gain.
Benefits of paying distributions
If an S Corp officer has paid themselves a reasonable salary, the best way to pay out year-end profits is a distribution.
An S corp bonus has to be run through payroll and it’s subject to Social Security and Medicare taxes. As such, S Corp owners have always tried to minimize wages and maximize distributions to avoid Social Security and Medicare taxes, but with the Qualified Business Income (QBI) Deduction, that objective has become even more critical.
The QBI deduction allows owners of pass-through entities to deduct up to 20% of their qualified business income. But that deduction applies only to leftover business income, not wages or bonuses. Effectively, this is like an additional tax on owner wages.
To illustrate, say Stark Industries is an S Corp with $100,000 in taxable income. The total profit of the S Corp before any owner wages was $220,000. The owner, Tony Stark, paid himself a reasonable compensation of $120,000. This brought business income down to $100,000.
If Mr. Stark gives himself a $10,000 S Corp bonus, his wages go up to $130,000, and business income goes down to $90,000. Now, his QBI deduction is only worth 20% of $90,000 instead of 20% of $10,000. He’s lost a $2,000 deduction. If Mr. Stark’s personal tax rate is 35%, he will owe an extra $700 in tax (35% of the lost $2,000 deduction). Plus, he still owes additional Social Security and Medicare taxes.
On the other hand, if Mr. Stark took the $10,000 as a shareholder distribution, the withdrawal would not be subject to Social Security and Medicare taxes. It would not impact his QBI deduction. The income from the S Corp was taxed when earned, not when distributed. So he doesn’t have to pay additional tax simply for withdrawing money from the S Corp.
Of course, the answer would look very different if the profit from Stark Industries before owner salary is $2.2 million, Mr. Stark’s salary is still just $120,000, and he’s considering a $2 million bonus. When an S-Corp owner’s dividend payment is that much higher than salary, this can make that company a target for an IRS audit.
Bottom line: do your homework, show that you’ve made a good faith effort to pay reasonable salaries. Then the IRS is more likely to defer to your judgment.