The Myth of the S Corp Salary 60/40 Rule: What You Need to Know

When it comes to S corporations, there are many misconceptions, and one of the most persistent is the so-called “60/40 Rule.” According to this rule, an S corp owner should allocate 60% of their income as salary and the remaining 40% as distributions to avoid IRS scrutiny. However, this rule is a myth and could lead to paying more in taxes than necessary. In this post, we will debunk the S corp salary 60/40 rule and provide clear guidance on how S corporation owners should properly determine their salary.

Understanding Reasonable Compensation

The IRS requires S corporation owners to pay themselves a “reasonable compensation” for the work they perform. This is to ensure that owners do not avoid payroll taxes by taking unreasonably low salaries and high distributions. However, the IRS does not specify a fixed percentage like 60/40 for salary and distributions. Instead, the determination of reasonable compensation depends on several factors:

1. Role and Responsibilities: The nature of your work, your duties, and your role in the company play a significant part in determining what a reasonable salary should be. If you are the CEO handling major responsibilities you should receive higher compensation compared to those who spend a lot more of their time with mundane tasks.

2. Industry Standards: Compensation for similar roles in your industry and geographic location can serve as a benchmark. Research what others in similar positions are earning to justify your salary.

3. Experience and Qualifications: Consider the owner’s level of experience, education, and expertise. More experienced and qualified individuals typically command higher salaries.

4. Time Spent Working: The amount of time you dedicate to the business is also crucial. Full-time involvement generally warrants a higher salary than part-time work.

Why the S Corp Salary 60/40 Rule is a Myth

The 60/40 rule is an oversimplified guideline that does not take into account the individual circumstances of each S corporation. Here’s why relying on this rule can be problematic:

1. Lack of IRS Endorsement: The IRS does not endorse or recognize any fixed percentage rule for determining S corporation salaries. The focus is always on what is reasonable based on the specific circumstances.

2. Variability Across Industries: Different industries have different standards for reasonable compensation. What might be acceptable in one industry could be unreasonable in another.

3. Risk of IRS Audits: Using a blanket percentage like 60/40 without considering your specific situation can increase the risk of an IRS audit. If the IRS finds that your salary is unreasonably low, you could face penalties and back taxes.

4. Overpayment of Taxes: A fixed percentage can lead to an over-payment of taxes. The IRS requires your business to pay a shareholder a salary that is “reasonable” based on the specific facts and circumstances. Applying a fixed percentage on a really profitable year leads to an overpayment of payroll taxes. Avoiding an overpayment of taxes is likely the reason you became an S corp in the first place. For example, lets say your business made $1 million dollars in 2024. If you followed the S corp salary 60/40 rule, you would pay yourself an annual salary of $600,000. Between the employee and employer portion of FICA, your payroll taxes would be $44,464. On the other hand, if you determined a reasonable salary for your role was $150,000, your payroll taxes would be $22,950. If you followed the 60/40 rule, you would be overpaying taxes by $21,514!

Best Practices for Determining Your S Corp Salary

1. Conduct Salary Research: Use resources like salary surveys, industry reports, and compensation databases to find out what others in similar roles are earning.

2. Document Your Decision: Keep detailed records of how you determined your salary. This should include data from your salary research, a description of your duties, and how much time you spend working.

3. Consult a Professional: Work with a CPA or tax advisor who has experience with S corporations. They can provide personalized advice and help you navigate the complexities of reasonable compensation.

4. Regular Reviews: Your salary should be reviewed and adjusted regularly to reflect changes in your role and industry standards.

Conclusion

The 60/40 rule is a myth that can lead S corporation owners astray. Instead of relying on this oversimplified guideline, focus on determining a reasonable compensation based on your specific circumstances. By doing so, you can ensure compliance with IRS requirements, avoid potential penalties, and an overpayment of taxes. Always consult with a tax professional to get the most accurate and personalized advice for your situation.

By understanding and applying these principles, you can make informed decisions about your S corp salary and distributions, ultimately benefiting both your business and your financial health.