What is Reasonable Compensation?

Reasonable compensation is a legal requirement for S-Corporation shareholder-employees.  It represents the value of the services provided by the shareholder-employee and must be paid via W-2 wages before any distributions are taken from the business. The IRS defines reasonable compensation as "the value that would ordinarily be paid for like services by like enterprises under like circumstances".  These rules apply to 'Inc.'s as well as LLCs that have elected to be taxed as an S Corporation or C Corporation. 

The importance of reasonable compensation lies in its role in ensuring compliance with payroll tax laws. W-2 wages are subject to payroll taxes, while distributions are not. Paying distributions without reasonable compensation may be viewed by the IRS as an attempt to evade payroll taxes.

Why is Reasonable Compensation Important?

For S-Corporations:

• Legal Compliance: All S-Corporation shareholder-employees must pay themselves reasonable wages before taking distributions. Failure to do so can result in IRS penalties, back taxes, and interest.
• Avoiding Reclassification: Distributions taken without reasonable compensation can be reclassified as wages by the IRS, subjecting them to payroll taxes, penalties, and interest on late deposits.
• Supporting Documentation: Completing a reasonable compensation analysis using one of the three IRS-approved approaches (Cost Approach, Market Approach, or Income Approach) and maintaining supporting documentation is essential.
• Avoiding IRS Scrutiny: High distributions with low wages can raise red flags and increase audit risks, especially during IRS field examinations.

For C-Corporations:

• Deductibility: Compensation must be reasonable to qualify as a deductible business expense. Unreasonably high compensation can result in disallowed deductions, increasing taxable income.
• Avoiding Reclassification: Excessive salaries in C-Corporations can be reclassified as nondeductible dividends, leading to additional taxation at both the corporate and shareholder levels (along with penalties and interest).
• IRS Scrutiny: Large, unjustified salaries may trigger audits, requiring robust documentation of compensation decisions (as well as other documentation generally required during an IRS field examination).

Key Considerations for Reasonable Compensation:

• Value-Based: Compensation must reflect the value of the services provided to the corporation by the shareholder-employees, not the business’s profits or distributions.
• W-2 Requirement: Shareholder-employees must receive W-2 wages before taking distributions. Wages can be taken without distributions, but not vice versa.
• Periodic Analysis: Conducting annual analyses ensures compensation remains reasonable. Adjustments should account for cost-of-living increases or inflation, especially if no formal analysis was performed during a particular year.

What Happens if You Don’t Take Reasonable Compensation?

• Financial Consequences: The IRS may impose back taxes, penalties, and interest.
• Preparer Penalties: Tax preparers may also face penalties for non-compliance.  If we notice non-compliance - we are obligated to tell you.  We don't want to be assessed penalties either!

Summary Tips:

• Calculate Periodically: Use one of the three IRS-approved methods to determine reasonable compensation on a periodic basis.
• Maintain Documentation: Keep thorough records to support your calculations.
• Seek Professional Advice: Work with your tax professional (CPA or EA) to ensure compliance and optimize your tax position.

How is Reasonable Compensation Calculated?

The IRS recognizes three approaches to calculating reasonable compensation:

1. Market Approach: Compares compensation to what would be paid for the same position in an arm's-length relationship at a similar company. Geographic location and industry standards are key considerations.
2. Cost Approach: Breaks down tasks performed by the employee, assigns wages based on proficiency levels, and aggregates these to determine a hypothetical replacement cost for the shareholder-employee.
3. Income Approach: Considers whether an independent investor would find the business’s financial performance satisfactory after accounting for the employee’s compensation. This method requires an accurate valuation (e.g. a formal appraisal) of the business and is less commonly used due to cost constraints (formal business appraisals are very expensive due to the level of work required to complete them).

Our Standard Practice:
We primarily use the Cost Approach, gathering detailed information through a questionnaire about roles, duties, and proficiency levels to calculate a hypothetical replacement cost. We then reconcile these findings with data from the Market Approach to provide a final reasonable compensation figure.  We then provide a detailed report with the suggested compensation figure after our analyses is completed.

The Bottom Line:

For S-Corporation shareholder-employees, paying reasonable compensation before distributions is a legal requirement. For C-Corporations, ensuring reasonable compensation protects the deductibility of business expenses and mitigates IRS scrutiny. Compliance demonstrates good faith and safeguards your tax position.

I'm Not Sure If My Corporation Is Reasonably Compensating Me - What Should I Do?

Reach out to your tax professional (CPA or EA)!  We're happy to help our clients determine their reasonable compensation figure.  If you're reading this and you are not a client of our firm - your tax professional likely also has tools that can assist them in helping make this determination.  If you own an S Corporation and have not engaged a tax professional (CPA or EA) to prepare your returns and consult on your specific tax situation - you should absolutely do so!  S Corporations are subject to complex rules related to shareholder compensation, distributions, ownership requirements, corporate-level deductions, and specific state-level elections.  Having an expert on your side can not only help you minimize your tax liability - but can also help you avoid 'blowing' your S-Election and prevent costly mistakes in the event of an examination.

Note: This article is provided solely for informational purposes and does not constitute tax, legal, or financial guidance by Clinton Winkles, LLC, its managing member, or its employees. No information herein should be construed as a recommendation for any specific action.  Before taking any steps that may effect your tax obligations, please consult your tax professional.

For any questions or to learn more about our services, feel free to view our website or contact us directly.