As a business owner, figuring out how much to pay yourself can be tricky. Paying too little or too much can lead to issues with the IRS if your compensation is deemed “unreasonable.” The good news? You can correct unreasonable compensation before an IRS audit, and in some cases, it may even make sense to amend prior years’ returns—but only in specific situations.
What Is “Unreasonable Compensation”?
In closely held corporations, particularly S corporations, the IRS monitors how much you pay yourself as an officer. If your salary is too low (or zero), and you take most income through dividends, the IRS may see this as an attempt to avoid payroll taxes. They might reclassify those dividends as wages and hit you with back payroll taxes and penalties. On the other hand, if you overpay yourself, the IRS could disallow part of your salary as a deductible business expense, increasing your corporate tax bill.
How to Correct Unreasonable Compensation
If your compensation seems out of line, here’s how you can fix it:
- Research Industry Standards: Look into what similar business owners in your field are paying themselves. Industry reports and salary databases are good places to start. Make sure your salary fits within that range.
- Document Your Role and Hours: Your compensation should match your duties. A higher salary is justified if you’re working long hours and wearing many hats. If your involvement is minimal, a lower wage makes sense. Keep records of your responsibilities to support your salary.
- Adjust Your Salary Going Forward: If your salary is too low and you rely on distributions, start paying yourself more. If it’s too high, adjust it to a reasonable level that aligns with your duties and industry norms.
Should You Amend Prior Year Returns?
Amending prior years’ returns to correct unreasonable compensation can be costly and complex. It would be best if you only considered this option in specific cases.
If your officer salary was reported as zero in past years, amending those returns might be necessary. Taking no salary while drawing dividends is a major red flag for the IRS. By amending, you can report a reasonable salary, pay the required payroll taxes, and potentially avoid larger penalties in an audit.
However, if your past salary was just a bit low, amending might not be worth the expense. In these cases, correcting your salary for future years is often sufficient to avoid issues.
Take Action Now
It’s better to correct unreasonable compensation before the IRS audits you. If your officer salary was zero in prior years, amending returns could help you avoid penalties. But if the difference is minor, adjusting your salary in the future is often enough to get back in line. Taking action now can save you stress and trouble later.
