What Is Reasonable Compensation?

Reasonable compensation refers to the salary that S corporation shareholder-employees must receive for services they provide to their business. The IRS requires that S corporations pay shareholder-employees a reasonable wage before making non-wage distributions. This compensation must reflect what would typically be paid for similar services in the marketplace.

Why Reasonable Compensation Matters

S corporations offer tax advantages because distributions beyond salary aren't subject to self-employment taxes. However, the IRS closely monitors S corporations to ensure owners aren't avoiding payroll taxes by taking minimal salaries and larger distributions. Getting reasonable compensation wrong can trigger audits, back taxes, penalties, and interest charges.

Determining Reasonable Compensation

The IRS evaluates reasonable compensation based on several factors:

1. Source of gross receipts - Three major sources determine appropriate compensation levels:
2. Services performed by the shareholder
3. Services performed by non-shareholder employees

4. Capital and equipment

5. Relationship to gross receipts - When most profits derive from the shareholder's personal services, most profit distributions should be allocated as compensation.

6. Administrative responsibilities - Shareholders should receive compensation for administrative work performed for income-producing employees or assets.

7. Market comparison - What would a non-owner performing similar duties earn in your industry and geographic location?

8. Time, qualifications, and experience - More skilled, experienced professionals command higher reasonable compensation.

Common Mistakes to Avoid

• Taking only distributions - S corporation owners must take a salary if they provide services.
• Setting unreasonably low salaries - Compensation should be market-based, not arbitrarily determined.
• Inconsistent salary practices - Drastically changing salary levels without business justification raises red flags.
• Poor documentation - Failing to document how compensation was determined weakens your position during an audit.

Documenting Your Reasonable Compensation

Best practices for establishing and documenting reasonable compensation include:

• Conducting salary surveys for comparable positions
• Creating job descriptions outlining responsibilities
• Maintaining corporate minutes documenting compensation decisions
• Tracking hours worked and services provided
• Consulting with tax professionals to validate your approach

Tax Implications of Reasonable Compensation

Getting reasonable compensation right affects several tax areas:

• Payroll taxes - FICA taxes (Social Security and Medicare) apply to salaries but not distributions
• Income taxes - Both salary and distributions are subject to income tax
• Qualified Business Income Deduction - Reasonable compensation can affect eligibility for this deduction
• Retirement planning - Higher salary allows for larger qualified retirement plan contributions

When to Review Compensation

Review your reasonable compensation structure: - When starting your S corporation - Annually during tax planning - When business conditions change significantly - When your role or responsibilities change - After major tax law changes

Conclusion

Reasonable compensation is not optional for S corporation shareholder-employees who provide services to their company. By understanding the requirements and documenting your approach, you can minimize audit risk while maintaining the tax advantages of your S corporation structure. Consult with qualified tax professionals to ensure your compensation strategy meets IRS requirements while optimizing your overall tax position.