Reasonable Compensation for S-Corporation Owners

Reasonable compensation

There are many tax benefits to filing as an S-Corporation, but you should be aware of additional responsibilities related to owner’s reasonable compensation or salary:

  • Reasonable Compensation is based on the value of the service provided, not profits or distributions.
  • Wages should be paid before distributions and must be paid via W-2.
  • A shareholder-employee can take wages without taking a distribution, but not vice versa.

If you aren’t sure if an S-Corp is right for you, reach out to us to run an Entity Planning Analysis to see what makes the most sense for your business.

What is Reasonable Compensation?

  1. All S-Corp shareholder-employees must pay themselves a reasonable salary (i.e. Reasonable Compensation) via W-2 BEFORE any distributions are taken. It’s the law.
  2. You should complete a Reasonable Compensation analysis each year using one of the three IRS-approved approaches.
  3. Keep a record of all supporting documentation for your figure each year.

Here is a link to the IRS definition of reasonable compensation

How Do You Calculate Reasonable Compensation? 

The IRS defines three approved approaches to calculating Reasonable Compensation: the Cost Approach, Market Approach, and Income Approach. Each approach is useful in different situations. We can help determine the appropriate approach based on your business.

What Happens if I Don’t Take Reasonable Compensation? 

If you don’t take Reasonable Compensation but do take distributions, you open yourself up to potentially large financial consequences, including back taxes, penalties, and interest levied by the IRS. The IRS may also revoke your S-Corp status, and preparer penalties can be levied on tax preparers.

There has been a lot of information in the news regarding the IRS funding outlined in the recent IRA22 legislation. One of the key takeaways is clear – the IRS intends to audit S-corporations at a much higher rate in the near future, specifically focusing on reasonable compensation.

Key Takeaways:

  1. Run a Reasonable Compensation analysis every year. Compensation changes over time, and so should your analysis.
  2. Document your Reasonable Compensation figure. Keep records of all data and calculations used in your analysis, which will be crucial if you are audited.
  3. Use unbiased data. The IRS prefers sources like the Bureau of Labor Statistics and the U.S. Census Bureau over websites like Glassdoor or Payscale.

The good news is that we have tools available that meet the above requirements and mitigate the risks associated with an IRS Reasonable Compensation challenge. If you would like to discuss this issue further and/or if you need assistance completing a Reasonable Compensation analysis , you can reach us by visiting our home page or filling out our online form to request a Free Consultation.

 

 

 

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