If you’ve elected S corporation status for your therapy practice, then you already know you need to pay yourself reasonable compensation in the form of a salary.
Great! Now you just need to figure out what a reasonable salary is, and how you go about setting it.
We’ll take an up-close look at this often-misunderstood term, and get hands-on with the process of setting your reasonable salary. But first, a quick review.
What is reasonable compensation?
When your therapy practice was a sole proprietorship, all your practice’s income and expenses were identical—for tax purposes—with your personal income and expenses.
So, if a client paid your practice $100 for a session, you personally received that $100 as gross income. If you paid $900 office rent, it was an expense you personally incurred—even though you can deduct office rent as a business expense.
Now that your therapy practice is an S corp, things are different. Any money you earn from your therapy practice has to come either in the form of a salary or as distributions.
Salary is money paid to an employee. A distribution is money paid out to shareholders. Since you’re both an employee and a shareholder, you can earn money both ways.
But here’s the catch: any salary you earn is taxed at a rate of 15.3%. That’s employment or so-called payroll tax.(If you’ve ever received a payroll stub as a W2 employee and looked at the breakdown of taxes withheld from your income, you would have seen that 15.3% tax listed.
Distributions you receive, however, are not charged payroll tax. And that’s why the IRS wants you to pay yourself a reasonable salary.
If your S corporation is brand new and you’re still not sure of the difference between salary and distributions, check out our complete guide to S corporations for therapists.
Why the IRS requires you to pay yourself a reasonable salary
Here’s a hypothetical: suppose your therapy practice, an S corp, earned $100,000 in 2023. In order to receive that money as personal income and use it to pay personal expenses, you need to earn it either as a salary or as a distribution.
If you paid yourself the $100,000 as a salary, you’d need to withhold 15.3% as employment tax—that’s $15,300. But if you take it all as a distribution, you don’t pay any employment tax. You could save that $15,300.
There were a lot of cases like this popping up where business owners who worked as day-to-day employees of their S corps didn’t pay themselves as employees. They paid themselves as shareholders instead, receiving distributions. That deprived the IRS of billions of dollars in employment tax each year.
So the IRS started cracking down, and now every S corp owner who works for their own company must be registered as a W2 employee and receive a salary. What’s more, that salary needs to be “reasonable.” You can’t pay yourself a $1,000 salary and take $99,000 in distributions.
What’s reasonable, you ask? It depends on your role, how much your practice earns, and how much other self-employed therapists in your area earn. To set a reasonable salary, you need to do market research.
What happens if you don’t set reasonable compensation?
If the IRS suspects you’re underpaying your salary in order to avoid paying taxes, they may audit you. And if they determine you should have paid yourself a higher salary relative to distributions you took, they can retroactively charge you employment tax.
The dangers of underpaying yourself
Suppose your profit in 2023 was $100,000. You paid yourself a $20,000 salary, took another $60,000 as distributions, and left $20,000 in the bank. That means the total you paid in employment taxes was $3,060.
The IRS audits you and, based on their own information, determines that $45,000 is a more reasonable salary, and that you should be paying 15.3% employment tax on $45,000 rather than $20,000. So they treat $25,000 of your $60,000 distribution as salary, and charge you employment tax on it.
Now, in addition to the $3,080 you already paid, you owe $3,825. What’s more, an IRS audit is able to back up to six years in your past. So if you underpaid yourself for those years, the IRS may go back and charge you added employment taxes each year, resulting in a hefty (and unexpected) tax bill.
Market research for reasonable compensation
Chances are, when you were setting your rates as a therapist, you did some research to figure out how much you should charge.
You may have checked out other therapists’ websites or directory listings to see what they charged. If you did, you would have taken into account their educational backgrounds, experience, and location, and compared them to your own.
Setting a reasonable salary is very similar to setting a reasonable hourly rate as a therapist. The most important part is finding out what other therapists are earning. Therapists’ salaries are affected by:
- The number of years they’ve been in practice
- The geographical area where they practice
- What types of treatment they offer
- Their level of education
There are a few resources you can turn to when researching therapist salaries:
- Free salary comparison tools like Glass Door, PayScale, and Salary.com
- Commercial salary comparison tools like RCReports (which specializes in reasonable compensation), or an accounting firm like SEK that offers reasonable compensation reports
- Person-to-person outreach, contacting therapists in your professional network who are comfortable sharing information about their past and present salaries
- An accountant with a large number of clients who are self-employed therapists (ask other therapists in your network for referrals)
Myth busting: the 60/40 rule for reasonable compensation
Some business owners recommend the 60/40 rule, or the 50/50 rule, for setting reasonable compensation.
Following this rule, each year you pay yourself 60% of your net revenue as salary, and the other 40% you take as distributions from the S corp. The split is 50% and 50%, respectively, if you follow the 50/50 version of this rule.
While it certainly doesn’t hurt to pay yourself the majority of your revenue as salary, this “rule” is really more of a guideline. The IRS doesn’t recommend any split in particular for paying yourself a reasonable salary, and there’s no proof the 60/40 approach is fail safe.
In fact, since business can vary in so many different ways from one another, there’s no one-size-fits-all solution. The best approach is always to set reasonable compensation based on the salaries other therapists earn.
Therapist reasonable compensation FAQs
How do I set a reasonable salary if I work part time?
Reasonable salary calculations are based on your working 2,080 hours per year. If you work less, calculate the number of hours you spend working each year as a percentage of 2,080, and multiply that by the reasonable salary for a full-time therapist. (For instance, if you work 1,040 hours per year, your salary should be 50% of what a full-time therapist earns.)
How do I pay myself a salary if I don’t know how much I’ll earn during the year?
For convenience’s sake, it’s best to set a regular salary, meaning one that doesn’t change from one payment period to the next. But you don’t have to pay yourself on a bi-weekly basis. You could cut yourself a paycheck every week, every month, or even every quarter. Also, if you find you’ve earned more than you expected, you can pay yourself a bonus (taxed as salary) at the end of the year.
I run a group practice and spend more time doing admin than I do seeing clients. How do I calculate a reasonable salary?
If you find yourself doing the duties of multiple roles for your practice, then you can calculate your salary based on the salaries of multiple roles. For instance, if you see clients part of the time, but also spend your working hours doing admin and social media marketing, the breakdown might look like this.
While researching salaries for a calculation like this, keep in mind your level of experience and certification in each role. For instance, you may have a Master’s degree and seven years of experience in clinical practice as a therapist. But you may have zero experience as an administrative assistant (consider running your own therapy practice on-the-job training). The salaries for each role should reflect that.
This is just an introduction to setting a reasonable salary for yourself as a self-employed therapist. As always, you’ll be guaranteed the best results by consulting with an accountant.
For a broader view of setting up and running an S corp, check out our complete guide to S corps for therapists.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult their own attorney, business advisor, or tax advisor with respect to matters referenced in this post.
Bryce Warnes is a West Coast writer specializing in small business finances.