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Reasonable Compensation in an S Corporation

by | Nov 28, 2023 | Business | 0 comments

The IRS has recently hired as many as 2500 new agents specifically trained in spotting shareholders who pay themselves too small of a salary while taking too many distributions. Catching these companies results in a big payoff for the IRS in the form of taxes, penalties and interest which are typically more than double the original tax that would have been owed. Plus, the company must pay for the costs to amend the returns involved. The IRS is also assessing preparer penalties to tax preparers of up to $5,000 for signing off on an unreasonable high/low compensation figure.

Types of Compensation
In every company where you are both an owner and do work as an employee, there are two types of compensation:

1. As an employee you should be paid a salary or wage for your hours worked.

2. As a business owner you should be entitled to distributions to pay the taxes that flow to your personal income tax return, pay for debt services, receive a return on capital invested in the business, and for time spent growing the business as an entrepreneur.

The main difference between a salary and a distribution is that salaries are subject to Federal and State payroll taxes, and distributions are not. As an owner of an S-corporation, although you would prefer all your income to be paid through distributions, the IRS would prefer it to all be wages to collect as much payroll tax as possible. And as they state in their initial letter approving the S-election, they can and will reclassify your distributions as compensation if they determine you are understating your salary.

The reverse dichotomy exists in C-corporations, so the IRS takes a reverse position on what is a reasonable salary in a C-corporation compared to an S-corporation. This fact is important, because reasonable should be reasonable regardless of whether a business is an S- or C-corporation, so we can use the IRS’s C-corporation reasoning against itself when deciding S-corporation salary.

Five Tests to Determine Reasonable Salary
The answer about what is reasonable is different for every taxpayer and it may change each year. There is no one-size-fits all answer, no percentage of net income, no salary-to-distribution ratio, and no threshold such as the social security wage cap to determine what is reasonable. Instead we look to the court cases involving taxpayers and the IRS battling over whether a specific circumstance was reasonable or not.

From various court cases, a multi-factor approach has developed and been adopted by the various US court systems to determine reasonable salary. There are many factors the courts considered, and the top five are summarized below:

Your qualifications and role in the company
What are your years of experience, education, training, and position in the business? As the years go on and you’re working longer hours with more experience you should consider raising your own salary. In addition to your profession, how much time are you spending as the company janitor,
bookkeeper, receptionist, etc.?

How well the business is doing?
Did your company have a bad year? One of the risks of running a business is that there are years of loss when it may not be able to afford to pay its employees, and it’s usually the owner who cuts his or her own salary to solve a temporary cash crunch in the business. It is fine in these circumstances to not pay your full reasonable salary based on the performance of the business, but you must always take 100% of your reasonable salary before taking any distributions.

Prevailing rates of compensation and external comparison to other businesses.
How does your salary stack up against your peers? How much would it cost someone else to hire you at a similar job in your area? How much would you pay to bring on someone with your exact same
experience and skill?

Salary policy of the taxpayer compared to all employees.
Is there internal consistency in how you and your employees are compensated within the business? Where does your salary stack up in the business? A good reality check is if you’re paying a new associate with less experience and skill more than you’re paying yourself for the same hours of
work, your salary is probably too low.

Hypothetical independent investor.
Frequently when an owner sells the business, the purchase agreement requires you to stay on for one or two years. What would your salary be for those years when you can no longer take distributions from the business? What would be the lowest pay you would be willing to work for at that point? Your current salary should be near that number.

No one of these tests is decisive, so you should thoughtfully consider each one when determining where to put your own salary in your S-corporation.

The Bottom Line
The hazards of paying too much or too little salary are clear. On the one hand, you could be needlessly paying payroll taxes on income you could take as an S-corporation distribution. On the other hand, you could receive a nasty letter from the IRS stating that they are assessing additional tax, underpayment penalties, and interest on payroll taxes you missed from having too low of a salary. While there is no perfect formula to determine what a reasonable salary is, you should carefully consider the factors above.

Research and Document
It is more important than ever that you have credible evidence as back up and that you research and document how you determined your reasonable compensation figure. The IRS criteria and guidelines state that “companies have the burden of showing compensation is reasonable.” To accomplish this and to avoid the 20% accuracy penalty the IRS states that:

a. The dollar amounts must be verifiable.
b. The taxpayer must be able to demonstrate the origin of the amount claimed.
c. The taxpayer must be able to show that he entered the amount in good faith.

Help is Available
At Integrated Tax Services we have the tools available to help ensure you meet all the above requirements. Come in and we will help create your personalized Reasonable Compensation Report, an independent,
unbiased report that uses criteria outlined by the IRS and Courts and provides a defensible position to an IRS challenge.

The best time to establish your reasonable salary figure is now, before an IRS examination, and we are here to help. Give us a call let’s start the conversation.