What Is Reasonable Compensation for an S Corporation Owner?

If you own an S corporation and actively work in the business, one of the most important tax considerations is reasonable compensation.

S corporation owners generally cannot simply take all of the company's profits as distributions to avoid payroll taxes. Shareholder-employees who provide services to the business generally need to receive reasonable compensation for those services.

What Is Reasonable Compensation?

Reasonable compensation is the amount an S corporation would reasonably pay someone to perform the same or similar work performed by the shareholder-employee.

There is no single salary or percentage that automatically qualifies as reasonable for every S corporation.

Instead, compensation should reflect the specific facts and circumstances of the business and the owner's role.

Why Does Reasonable Compensation Matter?

One potential tax advantage of an S corporation comes from the distinction between W-2 wages and shareholder distributions.

Wages paid to an owner-employee are generally subject to applicable payroll taxes. S corporation distributions generally are not subject to payroll taxes in the same manner.

Because of this distinction, paying an artificially low salary while taking large distributions can attract IRS scrutiny.

What Factors Determine a Reasonable Salary?

Several factors can help determine an appropriate compensation level, including:

• Duties and responsibilities

• Training and experience

• Time devoted to the business

• Industry and geographic location

• Comparable salaries for similar positions

• Size and complexity of the business

• Company's financial performance

• Compensation paid to other employees

The appropriate salary for a full-time consultant generating most of the company's revenue, for example, may look very different from compensation for an owner who performs only limited administrative duties.

Is There a 50/50 or 60/40 Rule?

You may hear business owners refer to rules such as paying 60% as salary and taking 40% as distributions.

There is no universal IRS rule establishing a fixed salary-to-distribution percentage that automatically makes compensation reasonable.

The appropriate compensation should instead be based on the value of the services actually performed.

Can You Take Distributions in Addition to Salary?

Yes. An S corporation shareholder may generally receive distributions in addition to W-2 compensation, subject to applicable tax and basis rules.

The important issue for an owner who performs services is that reasonable compensation should generally be established before relying on distributions as a way of taking additional money from the business.

What Happens If Your Salary Is Too Low?

If the IRS determines that compensation was unreasonably low, it may potentially reclassify some distributions as wages.

That can result in additional employment taxes and potentially penalties and interest.

Maintaining documentation supporting how compensation was determined can therefore be an important part of S corporation tax planning.

What If You Pay Yourself Too Much?

Reasonable compensation planning isn't simply about maximizing salary.

An unnecessarily high salary may reduce some of the employment-tax advantages that contributed to choosing S corporation taxation in the first place.

The objective is to establish compensation that is defensible and appropriate for the work performed, while considering the company's overall tax situation.

Review Compensation as Your Business Changes

A salary that was reasonable when your company was new may not remain appropriate as the business grows.

Changes in revenue, profitability, responsibilities, working hours, employees, and the owner's role can all affect compensation.

Reviewing owner compensation periodically can help keep the S corporation's payroll strategy aligned with the business.

Develop a Defensible S Corporation Compensation Strategy

Reasonable compensation is one of the most important ongoing responsibilities for an S corporation owner-employee.

James Ridout CPA provides reasonable compensation guidance, S corporation tax preparation, payroll support, tax planning, and S corporation election assistance for business owners.

Not sure how much your S corporation should pay you? Schedule a consultation with our team to review your situation.