Reasonable compensation
Reasonable compensation is the fair market value of the services a shareholder-employee provides to an S corporation. Under IRS guidelines, any distributions or other payments made to corporate officers must be treated as wages to the extent they represent compensation for services rendered.
This means that before an S corporation can distribute profits to its shareholders, it must first pay shareholder-employees a salary that reasonably reflects the value of their work.
For S corporation owners who are actively involved in the business, determining and paying reasonable compensation is not only a sound business practice—it is a legal obligation. The IRS requires shareholder-employees to be paid fair wages for their services to ensure proper reporting and payment of employment taxes, and to avoid potential audits and penalties.
Why Reasonable Compensation Matters?
Misclassifying earnings can lead to serious tax consequences. If the IRS determines that a shareholder-employee is receiving unreasonably low compensation, it may reclassify a portion—or all—of the distributions as wages. This reclassification subjects the income to payroll taxes and may result in significant penalties and interest.
Paying reasonable compensation is essential to comply with tax laws and to avoid triggering audits, back taxes, and other penalties. It demonstrates good-faith compliance and reduces the risk of scrutiny by the IRS.
The IRS closely monitors S corporations that report substantial shareholder distributions but little or no officer compensation. This imbalance is a well-known audit trigger. If flagged, the IRS may reclassify distributions as wages and assess additional payroll taxes, penalties, and interest.
Example:
Johny is the sole owner of an S corporation that earned $150,000 last year. He took the entire amount as distributions and reported no wages. The IRS audited his return, determined that at least $90,000 should have been classified as salary, and assessed payroll taxes, penalties, and interest. Misclassifying earnings can lead to significant tax issues. Remember:
if the IRS determines that a shareholder-employee is receiving unreasonably low compensation, it has the authority to reclassify distributions as wages, subjecting them to employment taxes and potential penalties.
How the IRS Evaluates Reasonable Compensation
The IRS does not use a fixed formula to determine reasonable compensation for S corporation shareholder-employees. Instead, it evaluates a range of factors, including:
The duties and responsibilities of the shareholder-employee
The amount of time and effort devoted to the business
The complexity and nature of the business
The individual’s training, education, and experience
Compensation paid for similar roles in comparable businesses
The corporation’s gross receipts and the role the shareholder-employee plays in generating them
For example, if most of the corporation’s income is directly tied to the services provided by the shareholder-employee, a higher salary may be warranted. On the other hand, if income is primarily produced by capital investments or other employees, a lower salary might be considered reasonable.
Determining and paying reasonable compensation is a fundamental responsibility for S corporation owners. It not only ensures compliance with IRS regulations but also safeguards the business from potential tax liabilities, penalties, and audits. By understanding the rules and implementing sound compensation practices, shareholder-employees can maintain tax efficiency and legal compliance.
Contact us today if you have questions or need expert guidance in determining appropriate compensation and to ensure your compensation strategy aligns with IRS standards.
