Reasonable Compensation for S-Corp Owners
Being a successful business owner comes with many responsibilities. As an S-Corp owner one of the biggest responsibilities can be determining what your reasonable compensation should be for the tax year.
What is reasonable compensation for S-Corporations?
Reasonable compensation is the appropriate amount for wages or salary that owners should pay themselves based on the services and work they provide to the business.
Why is it important?
Reasonable compensation for S-Corp owners is important to ensure that owners are being fairly compensated for the work they contribute to the company and to maintain compliant with tax regulations set by the IRS.
1. Tax Compliance: S-Corporations are offered a distinct advantage of being able to pass through the income, losses, deductions, and credits of the business to its shareholders. This allows the shareholders to report the S-Corp’s income on their personal tax returns, avoiding taxation at both the corporate and individual levels.
2. Avoiding tax pitfalls: Since S-Corporations have the distinct advantage of pass-through taxation the Internal Revenue Service keeps a watchful eye on the compensation paid to S-Corp owners to ensure that the wages paid out are reasonable. The IRS will keep an eye out for companies minimizing their tax liability by paying themselves as little as possible in wages to reduce payroll taxes and companies who seem to be categorizing a significant amount of corporate earnings as distributions (which could be subject to lower tax rates in contrast to employee taxes).
Why should I Maintain Documentation when Determining Reasonable Compensation?
Maintaining the documentations and factors you used to determine your reasonable compensation is important to remain IRS compliant. The documentation will serve as evidence for the effort taken to determine a reasonable wage. Having thoroughly documented records can help demonstrate that the decisions made were in good faith based on relevant factors. Documentation also provides a layer of legal protection and transparency. If the IRS conducts an audit or a review, having solid documentation helps establish and defend your decisions. This can minimize your legal risks and provides a track record that can be helpful for future decisions.
What are the IRS Guidelines for Determining Reasonable Compensation?
Sadly, the IRS does not offer a specific one size fits all formula to determine what your reasonable compensation should be. They instead insist that compensation should be based on the services and work provided by the owner to the company itself. The following is a list provided by the IRS that is factored in when determining reasonable compensation:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Dividend history
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
Compensation agreements
The use of a formula to determine compensation
Reasonable compensation can and will vary based on business factors and individual circumstances. By considering the above factors and maintaining a fair approach to compensation, S-Corp owners can ensure that their arrangement is reasonable and defensible if and when scrutinized by the IRS.