The concept in question pertains to a tool, potentially software-based, designed to assist in determining reasonable compensation for shareholder-employees of S corporations. It generally functions to estimate the appropriate salary level based on a benchmark, often interpreted as allocating approximately 60% of an S corporation’s profits to shareholder salary and 40% to distributions. This split is a simplified guideline; the actual allocation should be based on various factors. For example, if an S corporation generates $100,000 in profit, a calculator based on this guideline might suggest a salary of $60,000 and a distribution of $40,000. However, such a calculation is only a starting point and shouldn’t be the sole determinant of compensation.
The primary significance lies in facilitating compliance with IRS regulations. The IRS requires S corporation shareholder-employees who provide more than minor services to be paid reasonable compensation. This requirement aims to prevent tax avoidance, as salary is subject to payroll taxes (Social Security and Medicare), while distributions are not. By providing an initial estimate, these tools can help business owners avoid underpaying themselves and facing potential penalties or reclassification of distributions as wages during an audit. Historically, the absence of such resources led to uncertainty and inconsistent practices, resulting in increased scrutiny from tax authorities and the potential for costly tax adjustments.
