What Is Reasonable Comp & Why Should You Care?

Why Should Small Business Owners Be Concerned With Reasonable Compensation Issues?

S Corporation owner/employees are incentivized to pay themselves a ridiculous low or no salary as a result of the payroll tax savings.  The IRS is aware of the strategy of using modest S corporation salaries to reduce federal employment taxes for shareholder-employees. As a result, auditors pay substantial attention to this issue during an audit. If the Taxpayer is unable to substantiate that reasonable compensation was paid to the shareholder-employee, they can and will reclassify non-wage distributions to payroll compensation and assess payroll taxes on the reclassed amounts. The payroll tax assessment can be up to 40% of the non-wage distribution. In addition, penalties & interest will be assessed.

What Is Considered To Be Reasonable Compensation?

Well the IRS rules require you to pay yourself a "reasonable" salary for the work you do as an employee for the corporation.  (Rev. Rul. 77-44).  The IRS defines reasonable compensation as "The value that would ordinarily be paid for like services by like enterprises under like circumstances".  

It is not always easy to determine what reasonable compensation is but the IRS and the Tax Court look at several factors when there's a dispute over reasonable compensation.  IRS Fact Sheet 2008-25 lays out nine factors that the courts have considered:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history;
  • Payments to non-shareholder employees;
  • Timing and manner of paying bonuses to key people;
  • Payment by comparable businesses for similar services;
  • Compensation agreements; and
  • The use of a formula to determine compensation.  

We highly recommend that all S Corp owners undertake a reasonable compensation study at least annually.  The process starts with a questionnaire that asks about the roles the business owner plays in the company, the relative amount of time devoted to those roles, and a self-assessment of proficiency in those roles.  The study considers IRS criteria, court rulings, geographic data to produce a reasonable compensation amount.  

How S Corp Owners Should Pay Themselves

Business owner/employees should pay themselves the same as they would pay any other employee.  That means the business should:

  •          Have a set formula for calculating compensation, i.e, salary, hours, etc.
  •          Have a set payroll schedule i.,e weekly, semi-weekly, semi-month, or monthly
  •          Withhold payroll taxes from the owner’s paycheck
  •          Remit those payroll taxes to the IRS and state authorities
  •          Send a Form W-2 to the owner
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