Understanding Reasonable Compensation for S-Corps: What Every Business Owner Needs to Know

As a business owner running an S-Corporation, one of the most important tax decisions you’ll face is determining your reasonable compensation. It’s a topic that often gets overlooked but has significant implications for both your taxes and compliance with IRS regulations. Let me walk you through what reasonable compensation means, why it matters, and how to figure out the right amount for your specific situation.

What is Reasonable Compensation?

Reasonable compensation refers to the salary that you, as an owner-employee of your S-Corporation, must pay yourself for the services you provide to the business. The IRS requires that you receive a fair wage for the work you do before you can take any profits as dividends. The goal here is to prevent owners from skirting payroll taxes by taking lower salaries and larger distributions.

Why Does Reasonable Compensation Matter?

The distinction between salary and distributions matters for a couple of key reasons:

1. Payroll Taxes: Your salary is subject to payroll taxes, including Social Security and Medicare, while distributions are not. It may be tempting to pay yourself a lower salary and take larger distributions to save on taxes, but the IRS keeps a close watch on this practice. Paying yourself too little could result in penalties, interest, and additional taxes if the IRS decides your compensation isn’t reasonable.
2. IRS Audits: The IRS has increased its focus on reasonable compensation for S-Corp owners. If your salary is too low, the IRS can reclassify some or all of your distributions as wages, which would trigger back payroll taxes, penalties, and interest.

How to Determine Reasonable Compensation

There’s no exact formula to determine reasonable compensation, but several factors can guide you. The IRS typically considers a few key aspects to ensure your pay aligns with industry standards and the services you provide:

• Your Role in the Business: What do you do for the company? Are you serving as the CEO, marketer, bookkeeper, or wearing multiple hats? The more involved you are, the higher your salary should be.
• Industry Standards: There are databases available that can help you benchmark these salaries. The Bureau of Labor Statistics (BLS) provides comprehensive data on wages across various industries, job titles, and geographic locations. This is a common reference point to assess what a reasonable salary would be for a similar position in the industry. (U.S. Bureau of Labor Statistics : U.S. Bureau of Labor Statistics)
• Business Size and Revenue: Larger and more profitable businesses usually pay higher salaries. Your compensation should reflect your company’s revenue and its ability to pay you a fair wage.
• Time and Effort: Consider how much time you dedicate to running your business. If you’re working full-time (or beyond), your salary should reflect that level of commitment.
• Experience and Skillset: Your years of experience, level of education, and specific skills also play a role in determining what would be considered a reasonable salary.

How to Document Reasonable Compensation

To avoid IRS issues, it’s crucial to document how you arrived at your reasonable compensation. Here are a few ways to back it up:

• Salary Surveys or Industry Reports: Use data from salary surveys, industry standards, or expert compensation reports to justify your salary.
• Job Descriptions: Clearly outline your role within the business and how your pay aligns with your responsibilities.
• Comparison to Employees: If your S-Corp has employees, your salary should be comparable, adjusted for your role and duties within the company.

The Bottom Line: Get It Right from the Start

Determining reasonable compensation is essential for the smooth operation of your S-Corporation. It’s not just about minimizing taxes but ensuring compliance with IRS guidelines. Working with a tax professional can help you establish an appropriate salary and avoid costly mistakes down the road.

By paying yourself a reasonable wage, you’re not only staying within the boundaries of tax law but also setting your business up for long-term success.

How I Can Help

If you’re unsure about how to calculate your reasonable compensation as an S-Corp owner, I’d be happy to assist you. I can help you evaluate your role in the company, compare industry standards, and ensure that your compensation aligns with both your financial goals and IRS requirements.

Feel free to reach out to Stella Sanchez, CPA, and together we’ll make sure your business stays compliant while optimizing your tax strategy.