One of S corporation owners’ most crucial tax considerations is determining “reasonable compensation.” The IRS scrutinizes S corporation shareholders’ compensation because it impacts how income is taxed. While S corporation shareholders can take salary and distributions, only the salary is subject to payroll taxes. Distributions are not, making it tempting to underpay salaries. However, doing so can lead to IRS penalties if the salary is deemed unreasonably low.
What is Reasonable Compensation?
Reasonable compensation is the salary an S corporation owner must pay themselves for the services they provide to the business. The IRS expects this salary to reflect what someone in a similar role with similar experience would earn in the market.
The IRS looks at factors such as:
- The shareholder’s duties and skills
- Time and effort spent on the business
- Comparable salaries in the industry
- The company’s gross revenue and profits
How to Calculate Reasonable Compensation
1. Research Comparable Salaries
Use resources like the Bureau of Labor Statistics (BLS) or salary surveys to find salary data in your industry and region. For example, if the owner is both a CEO and performs technical work, combine salaries for those roles.
2. Consider Hours Worked
Estimate the time spent on each role and calculate compensation based on that split.
3. Factor in Company Financials
Your compensation should also reflect the financial health of your business. Higher profits may justify a higher salary while struggling businesses might opt for more modest compensation.
The Importance of Documentation
Maintaining documentation or a study to support your salary calculation is crucial. Without this, you leave the determination of what is “reasonable” to an IRS auditor if you’re ever examined. This could result in the auditor setting a higher salary than you paid yourself, leading to back payroll taxes, penalties, and interest.
If the IRS determines underreported wages, they will likely apply the adjustment to all three open tax years, increasing your liabilities.
Conclusion
Determining reasonable compensation for S corporation owners is critical to avoiding payroll taxes and penalties. To protect yourself in the event of an audit, be sure to document your approach based on industry standards, duties, and financial performance.
