One of the biggest perks of an S corporation is the potential to reduce payroll taxes. The lower the shareholder compensation, the less self-employment taxes they pay. Simple logic.
IRS Definition of Reasonable Compensation (warning: it's pretty vague).
But here's the thing. The IRS definition of reasonable compensation is pretty vague. On their website they say that reasonable compensation is "the value that would ordinarily be paid for like services by like enterprises under like circumstances". That leaves a lot to interpretation, don't you think? And by the way, notice anything missing? That’s right—no magic numbers like the “60/40” or “70/30” rule. That rule is not on there, because it was made up by us, accountants who constantly have to explain the topic of reasonable compensation to our clients. It's hard to explain an idea when you can't quantify it, right? So, sometimes we make up stuff, my apologies.
When it comes down to it, if you’re ever audited, the IRS expects you to show and defend how you arrived at your compensation figure.
Step One: Figuring Out Reasonable Compensation.
When determining reasonable compensation, the IRS looks at how the business makes money and the shareholder's role in generating that income.
The key question is: where do the company’s earnings come from? Did the shareholder work personally to generate that income, or did the income come from non-shareholder employees, contractors, or perhaps even shareholder investments in the company that started generating income on their own?
For example, if most of your revenue is generated by other employees or assets, then you can argue that you can take earnings as distributions, which aren’t subject to self-employment tax. But if the revenue is mainly from your own hands-on work, then the payment for that work should count as wages and be taxed as such.
This case comes up a lot with S Corps where shareholders are highly skilled professionals. Imagine a nurse practitioner who creates an S Corp for contract work with a hospital. Does this nurse have a right for drawing her income as distributions when all of her income came from her physical efforts and skills? She had no other employees and no assets generating passive income. The hospital paid the nurse $70 an hour, but why would the IRS settle for something less than this number?
As you can see, the definition is not clear cut and each situation is fact dependent. Which means, there is an option for proving your side. If you can prove, that the S Corp's income was generated by means other than your manual effort, please go ahead, pay yourself with distributions. But if you were also personally involved in the business, you would need to pay yourself a reasonable compensation. It is up to you to do the research and set your own salary.
Other Factors That Are Considered in Determining Reasonable Compensation.
This is what else is being considered:
- The employee’s skills, training, and experience
- How much work they did and the value of that work
- How complex the business is and the size of its operations
- What similar businesses pay for similar roles
- The history of compensation and bonuses paid by the business
- The company’s salary and profit distribution patterns
What are Ways the Business Owner Can Defend Their Reasonable Compensation?
Here is an idea:
- Break down your role into several job categories (As a small business owner, you probably handle multiple responsibilities—from bookkeeping to customer service and janitor). Calculate hours spent on each role, then research comparable hourly wages (try Indeed or the Bureau of Labor Statistics). Add it up for a defensible total.
- Use a compensation study. Or, if this seems like a lot of work, outsource all calculations to RCR Reports. We are not affiliated with them, but it's a solid company that focuses on reasonable compensation studies.
Timing of Compensation and Distributions: The IRS Requirements.
And another IRS rule. Ugh. The IRS says that the shareholder should pay themselves reasonable compensation before making any distributions. Why? Because the IRS wants to collect self employment tax. This means there are generally five ways how payouts happen in real life:
- Reasonable compensation plus distributions. This is a classic set up for healthy and thriving S Corporations, where the owner pays full amount of self employment taxes.
- Reasonable compensation with no distributions. This would make the IRS very happy. Sometimes we see in cases when the shareholder is approaching the retirement age and wants to catch up on their Social Security contributions. Sometimes this situation is caused by bookkeeping errors. Or sometimes reasonable wages for the profession are high (just like in the case with a nurse practitioner) and there is no legal way of reducing them.
- Pay neither wages nor distributions. If there are no distributions, the IRS generally accepts a “no wages” situation. But happens in future years when the shareholder decides to take distributions for both years? Well, before taking distributions, the shareholder must catch up and draw themselves a W-2 for both years. It’s unclear how many years the IRS might look back. A minimum of three years is a good rule of thumb, though there’s no official guidance.
- Wages less than reasonable compensation with no distributions. The shareholder is not required to pay themselves a salary if the business is loosing money. And indeed, where the cash would come from? Shareholder savings? Loans?
- Distributions only. This is obviously a red flag for an IRS audit. The IRS can see information on distributions on the shareholder's K-1. And the wages information ( or its absence) is also shown on the same tax return. Getting distributions only is obviously a wrong practice since the business owners avoids payments on self employment tax.
What Happens if the IRS Finds Unreasonable Compensation?
If the IRS decides that your compensation was unreasonably low, they’ll reclassify a portion of your distributions as wages and assess self-employment tax on that amount.
Strict? Yes. Reasonable compensation is what piques the IRS interest. They know that they walk away with a chunk of money and they also know that this is a gray area of taxation that often gets abused.
And now a little bit of self promotion. We are a boutique virtual CPA firm that helps business owners with their taxes and accounting. If you ever need help, please reach out! You can also check out our services here.