How to Determine Reasonable Compensation for an S Corporation
Ah, the term Reasonable Compensation. This topic has literally brought down Presidential Candidates (John Edwards, Google it). For those small businesses that elect to be taxed as an S Corporation, owners must take a “reasonable” wage for the work they provide in the business. Why?
You can read about the tax benefits of an S-Corporation in our previous blog post, but essentially the strategy is that the profit amount that you DON’T take as wages in an S-Corporation is not subject to payroll/self-employment taxes. Say the business has a profit of $500k, but you only take $100k in wages, you save the payroll/self-employment taxes on the $400k difference. The IRS doesn’t like that, hence the “reasonable” wage requirement.
But the IRS gives precious little guidance on determining that amount. In fact, if you search the IRS website on the subject, you receive zero results. What should a business owner do?
We advise our clients to pay an amount to themselves they can justify with external data. What would you have to pay someone else to do the things that you do in the business? For most business owners this is a difficult question because you wear a lot of hats. Is it what you would have to pay someone to do the invoicing and pay the bills or is it what you would pay someone to tell the employees what to do for the day?
My answer is, it doesn’t really matter. Just have some justification for what you pay yourself. Maybe you do only three primary things generally. Find out what you would have to pay someone full time to do that job, and pick the lowest amount.
The reason it doesn’t matter is because the IRS is not likely to fight you over it, if and when they do question it. As long as you have something to back it up. Here’s why.
The IRS has the exact same problem, only in reverse, for employees of regular C-Corporations. In that scenario, the strategy is usually to take as much compensation as possible to zero out the income of the corporation, thus avoiding income tax. The IRS uses the same “reasonable” compensation requirement for them as well. They’re stuck and can’t argue for extremes on either side.
The IRS has taken the stance practically that it should be “reasonable”, not stupid, and cover both situations. I wrote another blog post on it many years ago. Pigs get fat and hogs get slaughtered. The red flag is putting zero on the officer’s compensation line of the corporation tax return. That will get you audited quicker than anything.
If you have questions about your particular situation, shoot us an email with the specifics, and we’ll be happy to help.
