QUESTION ON How to Set Salary of Partners in S Corporation?
Hi, At present, I’m staying in VA. Recently I’ve started new firm (S Corp) and working as a contractor in DC thru’ my firm. I’m the only one working for the company. My wife is partner in the company, but she is permanent employee of some other firm. Estimated revenue of my company is around 120K/yr. What salary/compensation should I draw for myself? As my wife is partner, so is it mandatory to pay salary/compensation for her?
Congratulations on your new business. Let’s put the ownership of your company in proper perspective. The term “partner” usually refers to a co-owner in a partnership. But you indicated that you set up your business as an S corp. An S corp by any other name is still a corporation, and the owners of a corporation are called shareholders.
A shareholder of an S corp receives payment in the form of a distribution of profits in proportion to the shareholder’s percentage of ownership in the company. Shareholders generally do not receive salaries, unless they are also employees of the corporation. So if, by “partner”, you mean that your wife is simply a shareholder in the corporation and not an employee, she would take a distribution of profits but not a salary.
It is important to note that an officer of a corporation who performs services on behalf of the corporation is automatically considered by the Internal Revenue Service to be an employee. Therefore, if you are an officer of the corporation and perform services, you are an employee and must be paid a “reasonable” salary as discussed below.
Profits taken out of an S corp in the form of a salary are subject to employment taxes, but shareholder distributions are not. This presents an opportunity to save potentially thousands of dollars in employment taxes with an S corp. With this in mind, one might be tempted to take a ridiculously small salary and withdraw the remaining profits as a large distribution purely to maximize the employment tax savings–resist this temptation! This is a red flag for the IRS. With the small salary/large distribution approach, you run the risk of being audited, having your distributions reclassified as salary by the IRS and being subject to back employment taxes, penalties and late fees.
Instead, the IRS expects you to take a “reasonable” salary for the work that you do. “Reasonable” is a rather subjective term, but generally you can research the going salaries in your area for similar positions in your field to come up with an appropriate salary for yourself.
Best of luck!
Recommended Resources on How to Form LLC:
- LLC or Corporation?: How to Choose the Right Form for Your Business
- Surprisingly Simple: LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
- Nolo’s Quick LLC: All You Need to Know About Limited Liability Companies
- Form Your Own Limited Liability Company
- S Corporation Taxes for Employees and Shareholders
- S Corporation vs. LLC: Which Structure is Right for Your Business
- S Corporation Reasonable Compensation Tips
- Advantages of S Corporations
- Forming an LLC and Electing to be Taxed as an “S” Corp