Many small to mid-size marketing agencies struggle with reasonable compensation — not only for their employees but for themselves as well. If your agency is taxed as an S-Corp, the IRS says you must pay yourself a “reasonable compensation”. The lower your salary is, the less employment taxes you will pay. Therefore, the incentive for S-Corp owners is to have their compensation be as low as possible.

Any salary deemed too low could trigger an audit. Unfortunately, there are no hard and fast rules in determining reasonable compensation. Rather, there are a set of facts and circumstances the IRS considers when determining whether an S-Corp owner’s compensation is reasonable. Choosing the right range for compensation should always be a documented process that clearly shows how salary is determined and which is consistently applied.

But, first, some background on reasonable compensation

To understand reasonable compensation, it’s important to understand how S-Corporations work. As a closely-held corporation, an S-Corporation is a pass-through entity. Meaning: Tax is not paid by the S-Corp itself. It flows through to the owner. If you are the owner of an S-Corp, you will pay income taxes on your W-2 wages from the business, plus tax on the earnings from the business.

Because S-Corp income is not subject to self-employment tax, it’s easy to minimize salaries and take distributions, which are not subject to payroll or self-employment tax. S-Corps benefit when the actual wages are as low as possible and dividends are as high as possible. Why? Dividends are taxed at a lower rate than regular W-2 wages.

The IRS requires compensation of S-Corp owners to be reasonable. So, higher than zero, for sure, right? But the higher the better for the IRS, because they get to collect more payroll tax.

From Freelancer to Agency Ebook by Chris Hervochon CPA CVA

Yes, reasonable salaries also apply to one-person marketing agencies

If reasonable compensation rules apply to employees, are you considered an employee if you are the only person working in your marketing agency?

The short answer: Yes!

If you are providing substantial services to the S-Corp and even if you are the only person working in the S-Corp — yes! — you are definitely an employee.

And you aren’t alone.

More than 60% of marketing and advertising agencies employ 0 to 4 people, which means 1 to 4 people make up about two-thirds of all marketing agencies. (I don’t know how you can have a zero person agency — that’s the stat from IBISWorld industry market research).

This was decided in Joseph Radtke, S.C. vs. the U.S. The 9th Circuit Court ruled: “Where the corporation’s only director had the corporation pay himself, the only significant employee, no salary for substantial services … his dividends functioned as remuneration for employment.” What that means is if you’re the only person working in a marketing, advertising or creative agency — and you’re providing substantial services — then (most of) your dividends will be classified as wages.

If you’re just sitting at home providing no services to your agency and you’re only collecting checks, then maybe you have an argument. However, there is only one instance that I can find in which an S-Corp owner successfully challenged the IRS that they are not an employee, just a shareholder.

This is not the rule; it’s the exception

How do you calculate reasonable salaries for marketing agencies?

All of my marketing agency clients are S-Corps and this means:

they are taking a salary,
they’re on payroll, which is automated with direct deposit and paid on a normal schedule, and
taxes are remitted to the Federal and state governments

The amount of salary that should be paid on that schedule is reasonable compensation. Everything else that you take out of the business — when you cut yourself a check, when you go to the bank or when you take something out of the ATM — is a dividend.

Time and effort devoted to the business

If reasonable compensation is so important, you’d think there would be a formula to calculate it, right? There is absolutely and positively no formula to determine reasonable compensation. There are only legal cases that help provide a little bit of a road map, which tell us the IRS typically looks at training and experience, duties and responsibilities.

What kind of services do you provide to the business?

If you are the business, then, that’s going to be a significant amount. If you are the only person operating your S-Corp creative agency and your agency is making $100,000, it’s not reasonable for you to take a $2,000 salary.

The IRS also looks at dividend history. This includes payments to non-shareholder employees (this one is crucial). It’s important to not have employees who are paid more than you. If you’re working 80 hours per week, you’re going to have a really difficult time saying that you should be paid less than another employee who’s working 35 hours per week.

Let’s say you have an agency employee who is running Facebook ads, producing content or designing a website earning $45,000-$50,000 per year. As the agency owner, you provide significant time and you’re saddled with a lot of responsibilities. You should not be making $40,000 or $45,000 per year. Your employee with lesser responsibilities and time into the business should not make more than you, that’s a test the IRS will look at..

What similar agencies in your industry are paying

You should do a fair amount of research when deciding on your own salary. Take into consideration the current profitability of your business, and base your salary on the current rate for similar agency owners.

There is actually a court case in which the IRS recalculated somebody’s reasonable compensation using Risk Management Association (RMA) data, one of the data sources that accounting and finance professionals use to benchmark agences against other agencies. This information reveals owner compensation and employee compensation. There are other services that we use to determine what comparable businesses pay employees and owners.

Another great source is a Human Resources professional — or some sort of an outsourced HR professional who can tell you what similar businesses are paying their employees. Salary surveys, such as Robert Half, can help with this information as well.

Compensation agreements and other documentation

In the event of an audit, the IRS will expect documentation of the process your agency uses to determine salaries. It is critical to provide proof that all compensation being paid is for actual services rendered. Incentives should be earned in accordance with an employee’s performance. The timing, size and nature of bonuses paid will be scrutinized.

Do you have compensation agreements? If you hire freelancers, you will need their invoices and an independent contractor agreement (depending on your state). What kind of provisions are there? Do you use a formula to determine your compensation?

Have you standardized this in some way, shape or form? This is something that I definitely recommend, and a service I regularly provide for marketing agencies. I create a formula to determine what your compensation should be, based on the aforementioned benchmarking data, salary surveys, your actual agency revenue, etc. If you standardize reasonable compensation and continue to use that formula, this provides evidence that you are, in fact, trying to pay yourself reasonably.

The financial performance of your marketing agency

Another factor to determine reasonable compensation is the means of a business to pay. If your marketing agency is under-capitalized or you require great reinvestment, you can make the argument, “I can’t pay myself any more than this. Even though my agency was profitable, I can’t pay myself any more because those funds need to be used for reinvestment.”

If your marketing agency has $100,000 in gross revenue but your gross profit is only $20,000, you can’t pay yourself $25,000, right? You can’t put yourself in a worse capital position.

Also, the performance of the business relative to itself is important. Are you doing better this year than you did last year? If so, you should probably be making more money, right?

One of the factors I use for salary formulas is: How much is your agency making relative to itself and relative to your peers? With my marketing clients who work from home, they have very little overhead and they’re growing like gangbusters. They’re doing really, really well relative to themselves. I work with them to advise how their compensation should grow over time.

What are the implications of reasonable compensation?

Reasonable compensation is not one size fits all. Every agency and every situation is unique.

While there isn’t a standardized formula, there is a lot of case law that help us determine the factors for reasonable compensation. I take this information, my own research and my client’s current financial records, to create a standardized formula for reasonable compensation.

Finally, reasonable compensation is extremely important from a tax perspective. It impacts payroll taxes and also impacts the Qualified Business Income (QBI) deduction. You want your reasonable compensation to be reasonable, No. 1, but you want it to be as low as possible so that you’re paying the least amount of tax. From a tax perspective, it’s a lot cheaper to take dividends than to pay yourself a salary. However, this also should be balanced with other factors, such as the QBI deduction.

The bottom line is that It’s important to have a good understanding of:

what your reasonable compensation is and why,
what the reasonable salary should be, and
how the reasonable salary is going to impact your tax situation.

Resources to help:

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Why marketing agencies should pay attention to reasonable salaries