IRS Sticky Issue...S Corp Reasonable Compensation
S Corp Reasonable Compensation Requirement
Disclaimer – If you have a partnership or limited liability company that is not taxed as an S Corp and you are paying the partners/members/shareholders a W2 wage, you are operating incorrectly.
If you have a partnership or limited liability company that is taxed as an S Corp and you are paying the partners/members/shareholders a W2 wage, this blog is for you.
Every business that is taxed as an S Corporation has a requirement to pay its owners what the IRS calls, “Reasonable Compensation.” The IRS has verbiage, aka a warning, about this on the letter they send saying that you are approved to be an S Corporation. It’s their way of saying, “I told you so.”
Everyone seems to have a theory on what constitutes “Reasonable Compensation” but the only thing that matters is what the IRS says. Fortunately, this is an area they have spent time defining better over the last couple of years. I have no doubt that their intention on this topic will have an audit-related focus at some point in the future. So, it’s best to fix this now and protect yourself!
As an S Corporation owner, you cannot pick a number out of thin air to pay yourself. If you operate this way, you will not win in an audit.
I’ve had someone ask me before, "someone told us that we could determine our reasonable salary to be 50% of the profit," is that true? Nope, not true! Profit has nothing to do with determining what is reasonable to pay an owner for the work performed for the business. If you were to hire someone to do what you do, are you going to pay them 50% of the profit? Doubtful. Add a zero, or three for that matter, to your profit number and ask yourself if you would pay someone half the profit to do your work. The answer is no.
To the IRS reasonable compensation means the amount you pay someone to do all the jobs you do in the business for the many hats you wear. It is not determined by profit or loss, but by the various jobs performed to run the business, how much time you spend doing them, where you are in the country (because wages vary by state), and how competent you are at performing them. That is what the IRS would say, but they also say more.
If they were to audit your tax return, they could very well say that the money you take in distributions should all be wages. Yes, they have the power to do this. Then they would want Social Security, and Medicare tax for those wages as well as charge your penalties and interest for not paying those amounts timely, not to mention how you would have to redo your payroll reports and refile them for years back to the current because they wouldn’t stop with one year, they will then audit every year to the current year AND then they would pull your personal tax return into the audit for all the same years and recategorize those distributions as wages and at that point you are wondering when will it ever stop!
They can do that, and they will do it...and I've even seen it happen EVEN when a business showed a loss.
So, how do you determine a “reasonable salary”?
The rule of thumb on setting your compensation is that it must be “reasonable.” The IRS describes reasonable compensation as:
“An amount that would ordinarily be paid for like services by like organizations in like circumstances.”
In a nutshell: Pay yourself an amount like what businesses in the same industry pay for the same work and experience.
Here are a few other factors to consider when choosing a salary that’s comfortable for you and acceptable to the IRS:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
The use of a formula to determine compensation
The best thing you could do is have a report that justifies your salary for these reasons and keep it in your minute book ready to hand over to an IRS auditor if you ever find yourself across the table from one in an audit!