320 - Reasonable Salary Demystified
On today's episode of the podcast I'm sharing what's considered a "reasonable salary" when filing for a S Corp. If you missed last week's episode, go back and listen to part one of this two-part S Corp series.
In episode 319 we talked about how S Corps save you money, and the trick is you have to pay yourself a salary. The lower the salary is that you pay yourself, the more you save in taxes, but that salary has to be reasonable. So what is considered "reasonable" for tax purposes?
Coming soon we're launching a small cohort of my program Legally Launched to help you form an LLC or an S Corp or even if you want to make sure your sole proprietorship is legally legit, this program is for you. You'll keep your access to the program, so it can grow with your business and you can revisit it when you're ready to become an LLC or an S Corp.
We also have a S Corp Savings Calculator, available at notavglaw.com/scorpcalculator for $10. This will help you determine how much an S Corp can save you in taxes. The calculator is included in Legally Launched so if you know you're going to join the program you don't need to get it but if you're not sure if the program is for you yet, the calculator is a great stepping stone.
In my book, Unf*ck Your Biz, I have a chapter on S Corps, including a section on determining reasonable salary. To do so, you can look at the market rate of pay for someone offering your services in your geographic area with your level of expertise. Alternatively, consider how much you would pay someone to do what you do. What would be a reasonable amount of pay to find someone qualified to fill your role? The importance of this is that S Corps are subject to fraud abuse so the IRS may look at this through a critical lens. The way we can start to determine this is with a simple Google search to give us a good ballpark.
This is where it can get tricky. Often this can skew to the high side, and that's because we don't spend all our time necessarily doing that one thing. That's where the alternative Many Hats approach, a more popular salary calculation method for entrepreneurs. As a solopreneur you wear all the hats. You may start the day in your administrative work hat, then you put on your social media manager hat before another hat change into your core role. Consider the Many Hats approach a pie chart where each slice is sized by the time spent wearing each hat. This approach allows us to consider time spent on these tasks. We then calculate our salary by taking that percentage of the reasonable salary for reach job, for example 10% of your time on social media is 10% of the social media manager reasonable salary, etc.
I learned this the hard way. I looked up the (high) salary of a San Diego tax attorney. But only about 5% of my time is spent doing tax attorney work. The rest of my time is spent podcasting, speaking, doing social media, etc. When you do the Many Hats approach it can help pull your salary down which will help save you taxes. It just needs to be reasonable.
For example, if you have $100,000 in revenue and $50,000 in expenses you'll have $50k in profit. Let's say you wear four hats - web design (their primary), admin, social media and managing their team. If they spend 40% of their time doing web design with a reasonable salary of $70k, their percentage is $28k, social media, we'll say 20% of $50,000 for $10,000, for admin work we've got 20% of $60k at $12k, and management at 20% of $70k is $14k for a total salary of $64,000 which is $6k less than the $70k reasonable salary. This would save $918 in taxes.
This is not fool-proof, the IRS will be doing the same types of calculations on their end if you were to get audited. The most important thing to do is document everything when you calculate. Hyperlink screenshots of the reasonable salary numbers you find, don't just include the source link as average salaries change and if you get audited in a few years it may be higher than it was when you calculated so be sure to screenshot and date those. Note the tasks you do under each hat.
Worst case scenario if you miscalculate your reasonable salary, your penalty is going to be owing the difference in taxes on that salary difference plus some interest and penalties they decide to charge those to you. Not the end of the world unless you drastically underpay your salary.
If you're not about doing this math, you can use RCReports. You pay them a few hundred dollars and they ask you some questions about what you do in your business that they run through their algorithm to tell you what your reasonable salary would be and they give you a report you can give to the IRS if you're audited. I don't think this is necessary for everyone, I think it's more for businesses making six or seven figures in profit and wanting to pay themselves like $100k.