Demystifying the S Corp 60/40 Salary Rule: A Guide for Business Owners
For entrepreneurs and small business owners, structuring your company as an S Corporation can offer significant tax advantages. This potential for savings often leads to a crucial question: "How much should I pay myself?" One of the most talked-about, and most misunderstood, concepts in this area is the "S Corp salary 60/40 rule."
While this "rule" is often cited as a simple formula for financial success, the reality is more nuanced. The core principle behind it—balancing a formal salary with owner distributions—is central to the S Corp structure. Understanding how to determine a proper, defensible salary isn't just a matter of following a ratio; it's a critical business decision that directly impacts your personal income, your company's financial health, and your relationship with the IRS. This guide will break down the concept, separate myth from reality, and provide a data-driven framework for setting your compensation.
What is the S Corp "60/40 Rule" and Why Does it Exist?
First, it's essential to understand that the "S Corp salary 60/40 rule" is not a career or a job title. It's an informal guideline some business owners use to determine their compensation structure.
An S Corporation is a "pass-through" entity, meaning the company's profits and losses are passed directly to the owners' personal tax returns. An owner who actively works in the business is legally considered an employee and must be paid a "reasonable salary."
Here's the financial breakdown:
- W-2 Salary: This is formal wage paid to the owner-employee. It is subject to payroll taxes—Social Security and Medicare (FICA taxes), which total 15.3%. The corporation pays half (7.65%), and the employee pays half (7.65%).
- Shareholder Distributions: This is the remaining profit paid out to the owner. Distributions are *not* subject to FICA taxes.
The incentive is clear: by keeping the W-2 salary lower and taking more profit as a distribution, an owner can reduce their overall tax burden. The "60/40 rule" emerged as a popular rule of thumb suggesting that an owner should pay 60% of the company's net income as a W-2 salary and take the remaining 40% as a shareholder distribution.
Crucial Point: The "60/40 rule" is an oversimplified myth. It is not an official IRS regulation. The IRS's actual requirement is that S Corp owners must pay themselves "reasonable compensation" for the services they provide before taking any distributions. Arbitrarily applying a 60/40 split without justification can attract IRS scrutiny, audits, and significant penalties.
Determining a "Reasonable Salary": The Official IRS Stance
So, if the 60/40 rule is a myth, how do you determine a "reasonable salary"? The IRS states that reasonable compensation is the amount that a similar business would pay for the same or similar services. In short, you must pay yourself what you would have to pay someone else to do your job.
To determine this, you need to research market salary data for your specific role and responsibilities. Let’s look at some examples for common roles filled by S Corp owners.
- Management Consultant: According to Salary.com, the median salary for a Management Consultant in the United States is approximately $103,514 as of late 2023. The typical range falls between $91,550 and $117,117, with senior roles commanding much higher figures.
- Marketing Manager: The U.S. Bureau of Labor Statistics (BLS) reports the median annual wage for marketing managers was $140,040 in May 2022. The lowest 10 percent earned less than $79,490, while the highest 10 percent earned more than $208,000.
- General Contractor/Construction Manager: The BLS data from May 2022 shows a median annual salary of $101,480 for construction managers.
- Graphic Designer: For creative professionals, Payscale reports an average salary for a Graphic Designer of around $50,830 per year, with a typical range of $37,000 to $70,000 depending on experience and specialization.
The goal is to find a salary benchmark that reflects the value you bring to your company. Simply taking the lowest possible salary to maximize distributions is a red flag for the IRS.
Key Factors That Influence Your "Reasonable Compensation"
The IRS considers several factors when evaluating if your salary is reasonable. These are the same factors that dictate salaries in the open job market.
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Level of Education
Your educational background provides a foundation for your expertise and, consequently, your earning potential. A consultant with an MBA or a CPA license can justify a significantly higher reasonable salary than a competitor with only a high school diploma. Your formal training, certifications, and licenses are all documented proof of the value you bring, which helps justify a higher compensation level.
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Years of Experience
Experience is perhaps the most critical factor. An S Corp owner with 15 years of industry experience, a proven track record, and a robust professional network is far more valuable than a recent graduate. Your salary should reflect this. When benchmarking, compare yourself to professionals with a similar experience level.
- Entry-Level (0-5 years): Your reasonable salary will align with the lower end of the ranges cited above.
- Mid-Career (5-10 years): You can justify a salary near or slightly above the median.
- Senior/Expert (10+ years): Your compensation should reflect the upper quartile, as you are providing expert-level leadership, strategy, and execution.
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Geographic Location
Compensation is heavily influenced by the cost of living and market demand in your area. A business owner in New York City or San Francisco will have a much higher reasonable salary than an owner providing the same service in a rural area of the Midwest. The BLS provides excellent data on wage differences across metropolitan and non-metropolitan areas, which can be a valuable resource for justifying your salary based on your company's location. For example, the BLS notes that top-paying states for Marketing Managers include New York, California, and Washington.
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Company Performance and Complexity
The size and profitability of your company matter. The CEO of an S Corp with $3 million in annual revenue and 15 employees has far more responsibilities than a solo consultant generating $90,000 per year. Your salary should be commensurate with the complexity of your duties, the size of the budget you manage, and the overall financial performance of the business. A highly profitable year could justify a bonus (paid as W-2 wages) to supplement your base salary.
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Area of Specialization
Niche expertise commands a premium. A general IT consultant's reasonable salary will be different from that of a cybersecurity expert specializing in financial institutions. A family law attorney's compensation differs from a highly specialized patent attorney's. The more specialized and in-demand your skills are, the higher the reasonable salary you can justify. Researching salary data within your specific niche is crucial for accuracy.
The Risks and Rewards: Job Outlook for S Corp Owners
The outlook for entrepreneurs and small business owners remains a dynamic part of the U.S. economy. While the BLS doesn't forecast growth for "S Corp owners" specifically, it does track self-employment. The flexibility, autonomy, and direct financial rewards of owning your own business are powerful motivators.
However, the reward of tax savings comes with the risk of non-compliance. If the IRS determines your salary is unreasonably low, it can:
- Reclassify Distributions: The IRS can recharacterize your distributions (or a portion of them) as wages.
- Impose Back Taxes and Penalties: You will be required to pay the unpaid payroll taxes on the reclassified amount, plus penalties and interest.
This is why documenting your decision-making process is vital. Keep records of the salary surveys you reviewed, the job descriptions you compared your role to, and any other data you used to arrive at your salary figure.
Conclusion: Beyond the 60/40 Rule – A Smarter Approach
For any professional operating an S Corporation, understanding compensation is key to leveraging the structure's benefits effectively and ethically.
Here are the key takeaways:
- The "60/40 Rule" is a myth. It's an informal guideline, not an IRS-approved safe harbor. Relying on it without further justification is risky.
- Focus on "Reasonable Compensation." This is the IRS standard. Your salary should reflect what another company would pay someone to perform your job.
- Use Data to Justify Your Salary. Leverage authoritative sources like the BLS, Salary.com, and industry reports to benchmark your compensation based on your experience, location, and responsibilities.
- Document Everything. Keep a record of your research and the rationale for the salary you choose. This documentation is your best defense in a potential audit.
Ultimately, the smartest move any S Corp owner can make is to consult with a qualified Certified Public Accountant (CPA) or tax advisor. These professionals can provide personalized advice based on your specific situation, helping you determine a salary that is both reasonable and tax-efficient, ensuring your business is built on a strong and compliant financial foundation.