Understanding S-Corp Reasonable Compensation & FICA Tax Savings
Under United States Internal Revenue Code (IRC) Section 162 and Revenue Ruling 74-44, shareholder-employees of an S-Corporation who perform more than minor services are required to pay themselves a reasonable salary (W-2 wage) before taking shareholder distributions (K-1 dividends).
1. How the FICA Tax Advantage Works
For a standard sole proprietorship or single-member LLC, 100% of net business profits are subject to the 15.3% Self-Employment Tax (12.4% Social Security up to the annual wage base limit, plus 2.9% Medicare with no cap). By electing S-Corporation tax status (Form 2553), business owners split net earnings into two categories:
- W-2 Officer Salary: Subject to standard 15.3% FICA payroll taxes (half paid by employer, half withheld from employee).
- Shareholder Distributions: Exempt from the 15.3% FICA payroll tax, subject only to ordinary income tax.
2. IRS Audit Triggers & RCReports Benchmarks
Taking a zero salary or an unreasonably low W-2 wage (e.g. $20,000 on $250,000 net profit) is the #1 audit trigger for S-Corps. The IRS utilizes multi-factor benchmarks to challenge compensation, including geographic wage data, hours devoted, complexity of duties, and historical capital vs. labor contributions. Most CPAs recommend the 60/40 rule of thumb or an empirical wage survey (such as RCReports) to establish audit-proof compensation.
3. Frequently Asked Questions (FAQ)
Most tax attorneys and CPAs recommend making an S-Corp election once net business profits consistently exceed $70,000–$80,000 per year, which generates enough FICA tax savings to offset additional payroll processing and corporate tax filing costs.
Yes. Because Social Security benefits are calculated from your highest 35 years of covered wage earnings, reducing your W-2 wage reduces future Social Security retirement credits.