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As a business owner, wearing multiple hats is part of the job. But if you work in your business and own it, you can’t skip an important hat: being an employee. The IRS has specific rules requiring business owners who actively work in their companies to take a reasonable salary. Failing to do so can lead to serious tax consequences, including reclassification of distributions and hefty penalties. Let’s break this down.
The IRS Rule: Pay Yourself a Salary
Under the Internal Revenue Code (IRC) §531-§537, business owners face the Accumulated Earnings Tax if their corporations retain earnings beyond reasonable business needs without valid justification. But for S corporations and closely held C corporations, there’s an additional layer: Rev. Rul. 74-44. This revenue ruling allows the IRS to reclassify distributions (dividends) as wages if a shareholder-employee is actively working in the business but not receiving a reasonable salary.
Why does the IRS care? If you take distributions without paying yourself wages, you avoid payroll taxes—Social Security, Medicare, and federal unemployment taxes. The IRS considers this a misuse of the tax structure.
What Counts as a “Reasonable Salary”?
The term “reasonable salary” can feel vague, but it essentially means compensation comparable to what someone with your role and responsibilities would earn in a similar business. Factors the IRS considers include:
- Job Duties and Time Commitment
If you’re the CEO, marketer, and janitor of your business, the IRS expects your salary to reflect that level of involvement. - Industry Standards
Research what others in your industry and geographic area earn in comparable roles. Websites like the Bureau of Labor Statistics (BLS) can be helpful in estimating benchmarks. - Business Revenue
Your salary should be proportionate to the income your business generates. A multimillion-dollar business owner paying themselves $20,000 annually will raise red flags. - Compensation Mix
A mix of salary and distributions is common, but salary must be adequate before distributions can be taken.
Consequences of Non-Compliance
If the IRS determines your salary is unreasonably low—or nonexistent—it has the authority to reclassify all or part of your distributions as wages. This reclassification leads to:
- Back Payroll Taxes
You’ll owe Social Security, Medicare, and federal unemployment taxes on the reclassified amount, along with penalties and interest. - Increased IRS Scrutiny
Non-compliance can make your business a target for audits. Once the IRS flags your payroll practices, other areas of your tax return may come under review. - Possible Accumulated Earnings Tax
For C corporations, excessive earnings retained without justification can trigger additional taxes under IRC §531.
Best Practices for Staying Compliant
- Set a Clear Salary
Determine your salary based on market research, and ensure it reflects your contributions to the business. - Document Salary Decisions
Keep written records showing how you arrived at your salary. Include industry benchmarks, job descriptions, and company financials. - Pay Yourself Regularly
Salaries should follow a regular schedule, just like for any other employee. Avoid sporadic or “on-paper” payments that aren’t backed by payroll filings. - Separate Payroll and Distributions
Make sure your salary is processed through payroll, with proper withholding for federal and state taxes. Distributions should come only after paying yourself appropriately. - Work with a Tax Professional
A tax advisor can help you navigate IRS rules, set a reasonable salary, and ensure compliance with payroll tax laws.
A Word to S Corporation Owners
If you’re an S corporation owner-employee, this rule is especially relevant. The appeal of an S corporation lies in avoiding double taxation, but the IRS is vigilant about ensuring shareholder-employees don’t abuse the structure to avoid payroll taxes. Don’t assume the IRS won’t notice; they’ve successfully reclassified distributions as wages in numerous cases.
Final Thoughts
Running a business means understanding the line between tax optimization and non-compliance. Paying yourself a reasonable salary as an owner-employee is not just a good business practice—it’s the law. Failing to comply can lead to reclassified distributions, back taxes, and even penalties.
The good news? By following best practices and working with a trusted tax professional, you can stay on the right side of IRS rules while enjoying the benefits of owning your business. Don’t let poor payroll practices put your hard-earned business at risk.
