Reasonable Compensation: What No One Is Talking About

Whether you are new to owning an S-Corporation or have been operating your business as such for a while now, chances are that you have heard about the requirement of paying owner-employees a “reasonable compensation.” Many small business owners may still not fully understand this concept and therefore, may be operating their business in such a way that could mean IRS trouble if audited. This article will provide practical concepts on complying with this reasonable compensation requirement that is specific to S-Corporations.

What is reasonable compensation, and does it apply to you?

In general, reasonable compensation is the payment that would normally be paid for similar services by similar companies in your industry that are operating in similar circumstances. There is not hard fast rule that easily determines what amount is reasonable or not, instead it is based on various facts and circumstances.

Compensation is usually paid to employees and officers who also work in the business. If you are an officer in your business who only performs minor to no services at all to your S-Corporation, you would not be considered an employee and therefore you would not be subject to the reasonable compensation rules. However, most S-Corporations are setup by sole shareholders who would be considered an employee, meaning the income generated by the business is primarily from the shareholder-owner’s own efforts. If this is the case for you, you should understand how reasonable
compensation is determined.

What facts and circumstances do the IRS consider when making a determination that the amount of compensation you paid to yourself as an employee-owner is reasonable or unreasonable?

Generally, the IRS will take into consideration the following factors:

   • Your training and experience

   • Your duties and responsibilities

   • The time and effort you put into your business

   • The amount you pay to other non-shareholder employees

   • What similar businesses in your industry are paying for similar services (this is the most important consideration)

   • The formula you’re using to determine compensation

A great starting point for determining an income for yourself as a shareholderowner would be to look up salary ranges reported by the Bureau of Labor Statistics for your industry.

Why you can’t just take shareholder distributions from your S-Corporation?

A large number of tax professionals and/or tax preparers give poor or very little guidance in this area. We recommend highly that you work with a CPA or other tax professional who is an expert in small business due to the negative tax implications that not following the rules around reasonable compensation can bring. For instance, let’s say that a business owner you know, runs their business as an S-Corporation and paid themselves no compensation all year long, but instead just took withdrawals of cash from their business, what’s the problem with this?

Well, if they report all distributions on their S-Corporation’s tax return, the IRS can “re-characterize” these distributions as compensation. If this is done, the S-Corp owner will owe payroll taxes on the amount that has been classified as compensation or wages. This is not to say that you cannot make shareholder distributions from your S-Corporation, but to the extent that these distributions represent reasonable compensation, the distributions can be re-characterized and payroll taxes assessed. In closing, if you are an S-Corporation owner-employee who have not been properly paying yourself in your business, get with an expert immediately to determine a salary for yourself and get the help setting up payroll so that you can get in compliance with the reasonable compensation rule.