Losses, Timing, and the IRS View on Reasonable Salary
One of the most common tax questions business owners ask is:
“When should I switch from a single-member LLC to an S Corp?”
The short answer: Not during loss years—and not before profits are consistent.
The longer answer requires understanding two things:
- How losses and early profits are treated for tax purposes
- What the Internal Revenue Service expects when it comes to reasonable salary
Let’s walk through both with practical examples.
First, a quick refresher
A single-member LLC (SMLLC) is taxed by default as a sole proprietorship:
- All profit flows to Schedule C
- All profit is subject to self-employment tax
An S Corp is a tax election:
- The owner must be paid a reasonable salary (subject to payroll taxes)
- Remaining profit can be taken as distributions, which are not subject to self-employment tax
Important distinction:
An S Corp does not reduce income tax.
It only reduces self-employment (payroll) taxes—and only when there is profit after paying a reasonable wage.
Loss years: where Schedule C is actually better
Example: Year 1 – Startup loss
- Net loss: ($45,000)
Best structure: Stay a single-member LLC.
Why?
- The full loss flows directly to your personal tax return
- It can offset W-2 income or a spouse’s income
- No payroll, no payroll tax deposits, no added compliance
Electing S Corp status during a loss year usually:
- Creates payroll obligations even when cash is tight
- Adds cost without creating any tax benefit
Loss years are not S Corp years.
Small or inconsistent profits: still too early
Example: Year 2 – Modest profit
- Net profit: $25,000
This still isn’t S Corp territory.
Why?
- The IRS requires owners who work in the business to take reasonable compensation
- For a practicing veterinarian, that salary consume all of the profit
- Once payroll taxes and compliance costs are added, the S Corp provides little to no benefit
At this stage, simplicity matters more than structure.
The IRS position on “reasonable salary”
The IRS has been clear and consistent:
If you work in your business, you must be paid like someone doing that job.
In determining reasonable compensation, they look at:
- Duties performed
- Time spent in the business
- Training and experience
- Industry norms
- What it would cost to hire someone else to do the same work
What the IRS does not allow:
- Artificially low salaries
- Excessive distributions designed to avoid payroll taxes
This is one of the most common S Corp audit triggers.
What is a reasonable salary for a veterinarian who also manages the practice?
There is no single “correct” number, but there is a defensible framework.
For a veterinarian who:
- Actively practices medicine and
- Manages the business (team oversight, operations, leadership, decision-making)
A reasonable salary often reflects both roles.
Practical example:
- The veterinarian personally generates $500,000 of revenue
- A salary of $100,000 represents 20% production
This aligns well with:
- Market-based associate veterinarian compensation
- A defensible production-based benchmark
- IRS expectations for active owner compensation
Importantly:
Ownership alone does not justify paying yourself less than market.
When the S Corp does start to make sense
Example: Year 3 – Strong, stable profit
- Net profit before owner comp planning: $200,000
Possible structure:
- Reasonable salary: $100,000
- Remaining profit: $100,000 (distributions)
Result:
- Payroll taxes apply only to the salary
- Distributions avoid self-employment tax
- Potential annual tax savings: $10,000+, even after added compliance costs
This is where the S Corp becomes a tax optimization tool, not a startup experiment.
A common misconception: “Should I elect S Corp early to protect losses?”
No.
Losses are not enhanced in an S Corp.
They do not receive special treatment, nor are they more valuable later.
Electing too early often:
- Adds unnecessary complexity
- Increases audit exposure
- Creates payroll obligations during the least stable years
The healthiest progression for most practices
Many successful veterinary practices follow this path:
- Year 1: Loss → Stay Schedule C
- Year 2: Small profit → Stay Schedule C
- Year 3+: Consistent profit → Elect S Corp
This is normal.
This is expected.
This is good tax planning.
The key takeaway
An S Corp is not a startup strategy.
It is a profit-stage strategy.
Or said more simply:
The right time to switch to an S Corp isn’t when you’re optimistic.
It’s when profitability is real, repeatable, and defensible.