You’ve probably heard that S Corps can save in taxes. This is true. One major benefit of an S Corp is that it can save thousands of dollars in dreaded self-employment tax. All well and good, but there are rules and requirements that must be met in order to maintain S Corp status. One of those rules is that Owner-Employees of the S Corp must pay themselves “reasonable compensation.” The concept of reasonable compensation has significant tax implications for both the owner and the business, and understanding how to set reasonable compensation is crucial for tax compliance, minimizing the risk of audits, and avoiding penalties from the IRS.
What is an S-Corp?
Before diving into reasonable compensation, let’s go over some basics of what an S Corp is. Though often referred to as an entity (as I will do in this article), an S Corporation isn’t actually an entity at all. It’s an election made by an already existing entity. The entity (such as an LLC or corporation) makes an election to be taxed as a pass-through entity whereby all of the income and deductions flow through to its shareholders. The election avoids the double taxation faced by C Corps. Instead of the corporation paying taxes on its profits, the shareholders report their share of the business’s income or losses on their personal tax returns.
The Importance of Reasonable Compensation
Okay, back to this concept of reasonable compensation. For S Corp owners that work in the business (Owner-Employees), determining reasonable compensation is a must because it determines how their income will be taxed. S Corp owners are allowed to take two types of income:
- Salary/Wages: This is a salary or wage for the work performed. This income is subject to regular payroll taxes such as Social Security, Medicare, and federal and state unemployment taxes. It’s reported on a W-2 just like any standard 9-5 job.
- Distributions: These are profits distributed to the owner after the payment of reasonable compensation. This income is not subject to payroll or self-employment taxes. Whoo hoo!
As you can probably tell from the 2 income types above, S Corp Owner-Employees usually prefer distributions. This is where the problem arises. S Corp owners usually want to take a disproportionately large amount of income in the form of distributions, while paying themselves a minimal salary. In order to avoid this, the IRS requires the owner to take what is considered “reasonable compensation.” If the IRS determines that an S Corp owner’s wages are not reasonable, they may reclassify distributions as wages, subjecting the owner to back payroll taxes, interest, and penalties. No bueno.
What Is “Reasonable Compensation”?
The IRS does not provide any specific formula for calculating reasonable compensation. Instead, the determination is left to the facts and circumstances of each case. A general rule of thumb is that the salary paid to an Owner-Employee should reflect what would be paid to someone with similar skills and experience performing similar services in a similar industry. Though it’s subjective, I think most of us can agree that we wouldn’t expect a full-time CEO of a large tech company to be making an annual salary of $1,200.
Here are some key factors that the IRS and the courts will consider when evaluating reasonable compensation:
- The Role and Duties of the Owner-Employee: The nature of the work performed by the owner is pretty important. For example, an owner who works full-time in a business managing operations, marketing, and financial oversight would need to be compensated at a rate comparable to what a non-owner in a similar position would earn.
- Industry Standards: Reasonable compensation for the S Corp owner can in part be determined by using industry standards for salaries of business owners in similar roles. Businesses in different sectors—technology, construction, or retail, for example—have varying benchmarks for what constitutes fair compensation.
- The Business’s Financial Health: A highly profitable business will likely justify higher compensation for its owner, while a business struggling to keep the lights on may only be able to pay a modest salary. Still, this doesn’t mean an owner can set their salary arbitrarily low in order to avoid payroll taxes.
- Time and Effort Devoted to the Business: The amount of time an owner spends working in the business is another important consideration. If the owner works full-time, it’s reasonable to expect a salary that reflects a full-time employee’s compensation. If the owner only works part-time or has limited involvement, then the salary should reflect that level of engagement.
- Employee Compensation: In some cases, the compensation of other employees within the company may be relevant. If the owner is paying other employees a competitive wage for the same type of work, the owner’s salary should be within a similar range.
- Qualifications and Experience: The owner’s qualifications, including education, experience, and expertise in the field, are also taken into account when determining reasonable compensation. It’s completely reasonable that a highly experienced and skilled owner can command a higher salary than a less-experienced one.
Risks of Getting Reasonable Compensation Wrong
Here are some of the potential consequences S Corp owners face by undercompensating or overcompensating themselves:
- Compensation Reclass: As mentioned earlier, when an S Corp owner takes a minimal salary and relies heavily on distributions, the IRS may scrutinize the arrangement and argue that the owner is avoiding payroll taxes by classifying too much income as distributions rather than wages. If the IRS determines the salary is not reasonable, they may reclassify the distributions as wages, subjecting the owner to back payroll taxes, penalties, and interest.
- Excessive Compensation: Conversely, overcompensation of an S Corp owner can also be an issue. A salary that’s too high compared to what others in the same industry or role would earn may be flagged as excessive compensation. In such cases, the IRS may require the business to prove the legitimacy of the compensation and if it fails to do so, the IRS may disallow a portion of the salary and prevent the S Corp from deducting it as wages on its Federal tax return. This would lead to more profits passing through to the owner, which in turn means more taxes paid at the individual owner level.
Documenting and Justifying Compensation Decisions
As a best practice, S Corp owners should keep good records that document the rationale for their compensation decisions. This includes gathering industry salary data, comparing compensation levels, and keeping notes on the time and effort the owner contributes to the business. This documentation can save both headaches and time in the future in the event of an audit or inquiry from the IRS.
*Please note, all the information presented here is strictly for educational purposes and does not constitute tax or legal advice.
