S Corps: The Critical Rule You May Not Know About
If you own an LLC that's elected to be taxed as an S corporation, there's a critical tax rule you might not be aware of: the "reasonable compensation" requirement. Many LLC owners choose S corp taxation for the tax savings but don't realize they're required to pay themselves a reasonable salary. This oversight can lead to serious problems with the IRS. Let's break down what you need to know.
What Many LLC Owners Don't Realize
Here's what often happens: You elect S corp taxation to save on self-employment taxes, and your accountant or tax software helps you file the paperwork. You start taking distributions from your business and enjoy the tax savings. But nobody mentions that the IRS expects you to pay yourself a reasonable salary first.
Many LLC owners go years taking only distributions, thinking they're playing by the rules. The problem? The IRS can come back and reclassify those distributions as wages, hitting you with back payroll taxes, penalties, and interest. It's not a pleasant surprise.
The Tax Rules You Agreed To (Maybe Without Knowing It)
By default, LLCs are taxed as partnerships, which means all business profits flow through to you as distributions and you pay self-employment tax (15.3%) on those profits. That's Social Security and Medicare taxes on everything you earn from the business.
But when your LLC chooses S corp taxation, you get a different option: you can split your income between salary and distributions. The salary part gets hit with regular payroll taxes (15.3%), but any additional profits you take as distributions avoid those self-employment taxes entirely.
Here's the catch the IRS built in: you must pay yourself a "reasonable salary" before taking those tax-advantaged distributions. They don't want you paying yourself $10,000 in salary and taking $90,000 in distributions just to dodge most of your payroll taxes.
What Makes Compensation "Reasonable"?
The IRS doesn't give you an exact formula, but they want your salary to reflect what you'd pay someone else to do your job. Here are the key factors they consider:
Your role and responsibilities matter most. If you're the CEO of a multi-state cannabis operating making all the major decisions, you should be paid more than if you're doing nothing more than trimming. Consider how much time you spend working in the business and what specific duties you handle.
Industry standards are crucial. A cannabis consultant in San Francisco will have different compensation expectations than a small-town Northern Maine retail shop owner. Research what similar businesses pay for comparable roles in your area.
Your company's financial health plays a role too. A struggling startup can't be expected to pay the same salary as a profitable, established business. The IRS understands that compensation should be realistic given your company's circumstances.
Education, experience, and expertise factor in as well. If you have specialized skills, advanced degrees, or years of experience, that justifies higher compensation.
The Tax Advantage in Action
Let's say your LLC generates $100,000 in profit:
Without S corp election (partnership taxation):
$100,000 in distributions
Self-employment tax: $100,000 × 15.3% = $15,300
Plus income tax on the full $100,000
With S corp election:
$60,000 reasonable salary
Employee portion of payroll taxes: $60,000 × 7.65% = $4,590
Employer portion of payroll taxes: $60,000 × 7.65% = $4,590 (deductible business expense)
$40,000 in distributions (no payroll taxes)
Net effect: You save $6,120 in payroll taxes, and the company gets a $4,590 deduction
The hidden benefit for most businesses: With S corp taxation, the company can deduct its portion of employment taxes (Social Security and Medicare) as a business expense, which reduces the company's taxable income. This creates an additional tax advantage beyond just avoiding self-employment tax on distributions.
BUT there’s an important note for cannabis businesses: Because marijuana companies are subject to IRC Section 280E (which disallows most business deductions for cannabis companies), you generally cannot deduct the employer portion of payroll taxes either. This significantly reduces the tax benefits of S corp election for cannabis businesses, though the reasonable compensation requirement still applies.
The key insight: you're not avoiding income tax, just optimizing the self-employment tax portion while gaining a business deduction for the employer taxes paid (unless you're subject to 280E).
How to Determine Your Salary
Start by researching what others in similar positions earn. Check salary websites like PayScale, Glassdoor, or Salary.com for your job title and location. Look at what competitors might pay for similar roles, and consider hiring a compensation consultant if your situation is complex.
A good rule of thumb is to aim for the lower end of the market range if your business is still growing, and toward the higher end if you're well-established and profitable. Remember, you can always adjust your salary annually as your business evolves.
Special Considerations
For cannabis businesses: If your LLC operates in the cannabis industry, you're subject to IRC Section 280E, which prohibits most business deductions. This means you cannot deduct the employer portion of payroll taxes, eliminating one of the key tax benefits of S corp election. However, you're still required to pay reasonable compensation. Many cannabis business owners elect S corp taxation without realizing that 280E significantly reduces the expected tax savings.
Documentation is crucial: Keep detailed records of how you determined your reasonable compensation. This includes salary surveys, job descriptions, time tracking, and any professional advice you received.
Common Mistakes to Avoid
The biggest mistake? Taking only distributions and no salary at all. This is surprisingly common among LLC owners who elected S corp taxation but weren't properly advised about the reasonable compensation requirement.
Don't pay yourself an extremely low salary just to maximize distributions. A $15,000 salary when you're clearly doing $75,000 worth of work will likely get challenged by the IRS.
Don't forget that you need to run actual payroll for your salary. This means regular paychecks with proper tax withholdings, just like any other employee. You can't just call a distribution "salary" at year-end.
Also remember that while there's no penalty for paying yourself too much salary, you'll reduce the tax savings that made S corp election attractive in the first place.
Getting It Right (Before It's Too Late)
If you've been taking only distributions without paying yourself a salary, don't panic, but do act quickly. The sooner you start paying reasonable compensation, the better your position if the IRS ever questions your prior years.
The sweet spot is a salary that passes the "sniff test" – reasonable for your role and industry, but still allows you to take advantage of payroll tax savings on distributions above that amount.
Consider working with a tax professional who understands S corp and cannabis business taxation. They can help you benchmark your compensation and document your reasoning, which will be valuable if the IRS ever asks questions. If you've never heard of reasonable compensation before reading this, it's definitely time to consult a professional.
Remember, the reasonable compensation rule exists because S corp election gives you a tax advantage that partnership-taxed LLCs don't have. The IRS just wants to make sure you're not abusing that advantage.
The Bottom Line
Many LLC owners elect S corp taxation without fully understanding the reasonable compensation requirement. If that's you, you're not alone – but you do need to fix it. S corp election can provide real tax savings by letting you split income between salary and distributions, but those savings come with the responsibility to pay yourself fairly for the work you actually do.
The reasonable compensation rule isn't optional or a gray area – it's a firm requirement that comes with S corp election. Pay yourself a reasonable salary, document your reasoning, and then enjoy the tax benefits on your remaining distributions. And if you're just learning about this requirement now, don't wait to get compliant.
When done properly, this isn't about finding loopholes – it's about legitimately structuring your compensation to be both tax-efficient and compliant with IRS requirements.