For S corporation owners, reasonable compensation is crucial for staying compliant with the IRS. As both shareholders and employees, owners must pay themselves a fair salary based on their work. This is important because shareholder-employees receive funds through wages (subject to payroll taxes) and distributions (not subject to payroll taxes). If the IRS believes an owner is underpaying themselves in wages while taking excessive distributions, it can lead to audits, penalties, and back taxes.
But what exactly is considered reasonable compensation, and why does it matter?
How the IRS Defines Reasonable Compensation
The IRS defines reasonable compensation as pay reflecting the value of services provided by the shareholder-employee. The salary should match what the company would pay someone else for the same duties. When determining reasonable compensation, the IRS considers several factors:
- The Role and Duties Performed: Different jobs require different levels of compensation. For example, someone handling administrative tasks, like scheduling, would earn less than someone responsible for strategic planning or overseeing finances. The more complex and critical the role, the higher the pay should be. If an owner shapes the company’s vision or manages large teams, their salary should reflect that.
- Industry Standards: The IRS compares the owner’s pay to what others in the same role, industry, and region earn. Owners can use salary surveys to ensure their pay aligns with typical compensation for similar duties.
- Business Size and Financial Health: The IRS examines company revenue, profits, and size. Larger, profitable businesses are expected to pay higher salaries. A highly profitable S corporation that pays a modest salary but takes large distributions may raise red flags for the IRS.
- Time and Effort: An owner’s time in the business also matters. An owner working full-time in a key role should receive a higher salary than someone working part-time or doing less critical tasks.
Why Reasonable Compensation Matters
Avoiding IRS Scrutiny: The IRS monitors S corp owners who pay themselves low salaries while taking large distributions, which avoids payroll taxes. If they suspect underpayment of wages, it can lead to an audit.
Tax Compliance: Payroll taxes fund Social Security and Medicare. If the IRS reclassifies distributions as wages, the business will owe back payroll taxes, interest, and penalties.
Ability to Borrow: Reporting a fair salary helps when applying for loans or working with investors, showing that the company complies with IRS rules.
Conclusion
Understanding reasonable compensation is vital for S-corp owners to avoid IRS scrutiny. Pay should reflect the role’s complexity, align with industry standards, and consider the company’s financial condition. By balancing wages and distributions, owners can protect their businesses from penalties and keep operations compliant.
