Get to know the authorIt’s one of the most common questions among those evaluating business structures: What is a reasonable owner salary for an S corp? Knowing what a reasonable salary is — and how to determine one — is essential to reaping the benefits of S corp status.
In the right circumstances, those benefits can be significant. Forming an S corp can greatly reduce self-employment taxes, which can result in major savings.
Below, we’ll discuss what a reasonable salary is, how to determine one, and how S corps are taxed.
What is a reasonable owner salary for S corps?
An owner salary is the amount of income that the owner or owners of an S corp receive in exchange for the services they provide to the S corp. Owners who actively participate in S corp operations are required to pay themselves a reasonable salary, to prevent them from shielding themselves from self-employment or payroll taxes entirely through the S corp structure.
Generally, you can think of a reasonable salary as the going market-rate salary for the services the owner has provided to the business. According to the IRS, a reasonable salary must be similar to what you would receive for performing similar services for a similar company in similar circumstances.
Additional factors a reasonable salary should take into account include:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
How to determine a reasonable salary
The best place to start when determining a reasonable salary is usually by researching market compensation.
The Bureau of Labor Statistics (BLS) wage data is generally the most reliable source, but you can also reference local job postings and sites like Glassdoor, PayScale, and Salary.com. Using salary information from these sources, you can arrive at a figure in line with the median.
Other common methods to determine a reasonable salary
Two other popular ways of determining a reasonable salary include the:
- 60/40 Rule: Classify 60% of your business income as salary, and the remaining 40% as dividends
- 50/50 Rule: Classify 50% of your business income as salary, and the remaining 50% as dividends
Note:
Keep in mind that these guidelines are rules of thumb rather than official formulas — the IRS does not endorse either one. If the salary you assign yourself according to either of these rules falls way short of the median, it may raise red flags with the IRS.
S corp taxation & benefits
Before we jump into the specifics of reasonable salary for US expats, let’s go over how the IRS taxes S corporation owners.
S corporations, or S corps, are pass-through entities — businesses that “pass” taxation down to individuals within the organization rather than paying corporate taxes. In S corps, the individuals responsible for taxation are the shareholders.
There are two types of S corp shareholder income: salary and distributions. Salary income is subject to two types of taxation:
- Ordinary income taxes: 10% to 37%, depending on overall income earned
- Self-employment taxes (aka social security or payroll taxes): 15.3% (12.4% for Social Security, 2.9% for Medicare)
Distributions are only subject to ordinary income taxes. Since you don’t have to pay self-employment taxes on distributions, this type of income is much more tax-efficient. Additional benefits of S corp status can include qualifying for unemployment and expensing health insurance premiums, among others.
To ensure that S corps help fund Social Security and Medicare, you must pay shareholders a salary. Paying in distributions only, after all, would completely bypass self-employment taxes.
Moreover, to ensure that S corps pay their fair share of Social Security/Medicare taxes, you must pay a “reasonable salary.” By paying self-employment taxes on a $1 salary and not on $99,999 in dividends, for example, you wouldn’t be contributing to the system for your earned income, like others do.
Pro tip:
S Corps are generally more expensive and complex to form and maintain than sole proprietorships or LLCs. For tax savings to offset the administrative costs and burden, you’ll need to be a relatively high earner. While there’s no magic number, a minimum of $80,000 to $100,000 in business income is a good rule of thumb.
Business income & tax implications for expats
Living abroad comes with its own tax implications, so US expat S corp owners should take additional considerations into mind.
Avoiding double taxation
If you’re a tax resident of another country, odds are you’ll be subject to income taxes by their government. And because moving abroad does not absolve American citizens and permanent residents of their US tax obligations, you’ll need to file US taxes as well.
Fortunately, there are a few ways to avoid also paying tax twice.
The Foreign Tax Credit
By claiming the FTC, expats receive dollar-for-dollar credits on foreign income taxes they pay. They can then apply these credits toward their US tax bill. If they live in a country that has higher income tax rates than the US, this will usually offset their whole tax liability. It will also give them surplus tax credits they can apply toward future tax bills.
In countries with low taxes, though, the FTC may be less beneficial.
The Foreign Earned Income Exclusion
The FEIE allows Americans who pass the Physical Presence Test or Bona Fide Residence Test to exclude a certain portion of the foreign-earned income from taxation. For the 2023 tax year (aka taxes you pay in 2024), you can exclude up to $120,000. In tax year 2024, that figure increases to $126,500.
Note that you cannot exclude passive income like rental income, investments, or dividends — including S corp dividends.
Note:
Expats living in a country that has a tax treaty with the US may be able to claim its benefits. However, tricky “saving clauses” that allow the US to disregard most of these agreements when it comes to taxing US citizens render them largely ineffective. Claiming one of the tax breaks mentioned above is usually more effective in avoiding double taxation.
Totalization agreements
Dozens of countries have agreements with the US that prevent nationals of one country residing in the other from paying social security taxes to both. Countries with US totalization agreements include Canada, the UK, and most of the EU (among others).
Living in a country with a totalization agreement often reduces the tax benefits of having an S corp. Let’s say you live and work in Italy year-round. To receive social benefits in Italy, you must pay Italian social security taxes.
By applying the US-Italy totalization agreement, you can exempt yourself from US social security taxes. In that case, you wouldn’t need the additional reduction in US self-employment taxes that an S corp provides.
However, some expats must pay US social security taxes regardless, such as those who:
- Live in a country without a totalization agreement (e.g. Mexico, China, New Zealand), OR
- Move from country to country so often they don’t pay into any other country’s social security system (i.e. a true digital nomad)
In those cases, S corp status (and the subsequent reduction of self-employment taxes) could be a major boon.
Reporting implications
Creating an S corp generally means you have to file different (and sometimes, additional) reports than you would as a sole proprietor or LLC. For example, rather than the standard personal income tax return (Form 1040), you’ll file Form 1120-S.
Living abroad may also add to or change your reporting obligations — for example, you may need to file the:
- Foreign Bank Account Report (FBAR): Required for those who have over $10,000 across foreign financial accounts.
- Statement of Specified Foreign Financial Assets (Form 8938): Required of those with over $200,000 in foreign assets on the last day of — or over $300,000 in foreign assets at any point during — the tax year.
Note:
Those living in the US may also need to file Form 8938, but their reporting threshold is much lower — $50,000 in foreign assets on the last day of the tax year, or $75,000 in foreign assets at any point during the year.
The easy way to optimize your taxes & stay compliant
Forming an S corp can benefit high-earning US expats in the right circumstances. This is especially true if you’re a digital nomad or live in a country without a totalization agreement.
But remember, while market research can help you determine a reasonable salary, it’s no substitute for professional advice.
