If you’re a shareholder in an S Corporation, ensuring that your compensation is reasonable is crucial to avoid IRS scrutiny. But how do you calculate and document reasonable compensation? Follow this straightforward process to establish a well-supported, defensible compensation figure using publicly available data and clear documentation.
Step 1: Download State Wage Data
The Department of Labor (DOL) releases annual wage data by state each May. This dataset provides a comprehensive breakdown of average wages for different occupations and industries in your area. Start by downloading this data and importing it into a spreadsheet. This will serve as your baseline for determining reasonable pay rates.
Pro Tip: Focus on your specific state to ensure your compensation aligns with local economic conditions. Bookmark the DOL website or set a reminder each May to update your data.
Step 2: Identify Major Duties
Make a detailed list of your primary job responsibilities as a shareholder-employee. Most shareholders in S Corporations wear multiple hats, so aim to capture 4 or 5 major functions you perform regularly. For example:
- Sales and Business Development
- Operations Management
- Financial Oversight
- Customer Support
- Administrative Tasks
Defining your roles ensures you match each duty to an appropriate wage category.
Step 3: Look Up Average Pay Rates
Using your spreadsheet of DOL wage data, find the average hourly rate for each of your identified duties. For instance:
- Sales and Business Development: $45/hour
- Operations Management: $50/hour
- Financial Oversight: $55/hour
- Customer Support: $25/hour
- Administrative Tasks: $20/hour
Make sure the rates reflect your state and industry. If necessary, adjust based on the experience required for the role.
Step 4: Allocate Your Time by Duty
Next, estimate your time on each duty during a typical workweek. Break this down as a percentage, ensuring the total does not exceed 40 hours per week. For example:
- Sales and Business Development: 40% (16 hours/week)
- Operations Management: 25% (10 hours/week)
- Financial Oversight: 15% (6 hours/week)
- Customer Support: 10% (4 hours/week)
- Administrative Tasks: 10% (4 hours/week)
Allocating your time helps demonstrate how your compensation correlates with the value of your work.
Step 5: Calculate Total Compensation
Now, multiply the hours spent on each duty by the corresponding hourly rate, then sum the totals:
- Sales and Business Development: 16 hours × $45/hour = $720
- Operations Management: 10 hours × $50/hour = $500
- Financial Oversight: 6 hours × $55/hour = $330
- Customer Support: 4 hours × $25/hour = $100
- Administrative Tasks: 4 hours × $20/hour = $80
Total Weekly Compensation: $1,730
Annualized Salary (52 weeks): $1,730 × 52 = $89,960
This total represents a well-documented, reasonable compensation figure that reflects your duties and local wage standards.
Why This Approach Works
By following these steps, you’re creating a clear paper trail that aligns with IRS guidelines. Using third-party wage data, documenting job duties, and allocating time builds a solid defense if your compensation is questioned. It’s proactive and transparent and ensures you remain in compliance.
IRS Agents are used to seeing taxpayers with no documentation. Yours does not have to be pretty to be adequate.
Bonus Tip: Keep this documentation updated annually and include it with your corporate records to show consistency.
