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Reasonable compensation, or reasonable salary, is an important compliance aspect of being an S Corp owner that’s often overlooked — and misunderstood. It’s important to set reasonable compensation at the appropriate level because if you set it too high, you could be overpaying payroll taxes. But if it’s set too low? There’s the risk of the IRS reclassifying distributions as wages, which can result in owing back taxes, penalties, and interest.
In this guide, we’ll explain what reasonable compensation is, how it works, and ways to set appropriate levels as an S Corp owner.
What is reasonable compensation?
First and foremost, the IRS defines reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” There are a couple of different ways you can think about this:
- Replacement cost: If you had to go out into your community and hire someone as a replacement for all the services and tasks that you perform, what would you have to pay them?
- Fair market value: If you were to close your business and work for a competitor performing the same services and tasks that you currently perform, what would the competitor pay you for those same services?
Per the IRS Fact Sheet, here are some of the factors used to determine 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
The IRS requires reasonable compensation to be paid as W-2 wages before distributions are taken. By taking this step, S Corp owners pay their full share of payroll taxes before taking distributions, which are not subject to payroll taxes.
Now that we’ve covered the basics of reasonable compensation, let’s explore how business owners can figure out what to pay themselves and some common scenarios they may come across.
How to pay yourself as an S corporation owner
The first step when determining how much to pay yourself as an S Corporation owner who actively works in the business is to determine your reasonable compensation figure. This is essentially an assessment of the fair market value of the services you perform for your business.
Once you understand what your reasonable compensation figure is, you can:
- Evaluate whether you should only take wages
- Take wages and distributions from the business.
Be confident about reasonable compensation
One of the easiest and most reliable ways to determine your reasonable compensation (and the most defensible if you are ever audited) is to complete a professional reasonable compensation analysis. RCReports offers one of the best reports you can find, and it takes less than 10 minutes to complete.
One of the biggest advantages of being an S Corporation is the tax savings from taking distributions that are not subject to payroll taxes. However, to take distributions, you must first satisfy the IRS requirement to take reasonable compensation as W-2 wages, which are subject to payroll taxes.
Once you understand what your reasonable compensation should be, there are a few different scenarios that could play out.
Scenario 1: You don’t have enough cash to pay your full reasonable compensation amount
If you don’t earn enough in your business to pay your full reasonable compensation amount, that’s OK! This means that any money that you do take out of the business must be paid as W-2 wages. As long as you aren’t taking distributions, you are in compliance with the IRS’s reasonable compensation requirement.
Scenario 2: You only take reasonable compensation but no distributions
If the only money that you want to take out of your business is the amount of your reasonable compensation figure, that’s within the rules too! Just make sure that you are taking all of this money out as W-2 wages.
Scenario 3: You take reasonable compensation and distributions
Let’s say you want to take out a total of $150,000 from your business this year. You’ve completed a reasonable compensation analysis to determine whether you should pay yourself $90,000 in W-2 wages. Once you’ve paid yourself these wages, you can take out the remaining $60,000 as distributions, which are not subject to payroll taxes.
Just make sure that you are not falling into Scenario 4, which involves only taking distributions and no W-2 wages. This can attract unwanted attention from Uncle Sam, and your chances of an audit are likely to increase with this approach.
It’s worth noting that S Corporation shareholders who do not work in the business are not subject to the reasonable compensation requirement and can take distributions out of the business that are not subject to payroll taxes as long as these distributions do not exceed the shareholder’s stock basis. Next, let’s cover some common pitfalls and how to avoid them.
Avoid common risks with reasonable compensation
If you are audited by the IRS and you have taken distributions out of your S Corp, the IRS can initiate a reasonable compensation challenge. Typically, reasonable compensation challenges occur after an S Corp is selected for a payroll audit. During this process, an auditor will examine the amount of the W-2 wages that you paid yourself to see whether this amount is ‘reasonable’. If you were found to have underpaid your salary — and therefore overpaid your distributions — costs can add up quickly.
In many cases, non-compliance costs include:
- Back taxes
- Penalties and interest
- Fees paid to a CPA and/or lawyer who represents you in the audit.
While these amounts vary by situation, they typically amount to approximately 30% of the unpaid wages, plus any representation fees.
For example, if the IRS says your reasonable compensation should have been $60,000, and you paid yourself $50,000, you will likely be looking at around $3,000 to settle up with the IRS (and that’s without any fees you may rack up for audit support from your CPA and/or lawyer). On top of that, audits typically don’t just look at one year, they look at two to three years, so there’s potential for costs to rise even higher.
Data to back up decisions
If you find yourself in a tight spot, the best thing you can do is purchase a reasonable compensation report to provide to the IRS. Having a fact-based figure before they come up with a number on their own can go a long way in helping your case.
Another thing to watch out for as an S Corp owner is the possibility of overpaying your salary, which can result in overpaying taxes. So, how can you strike a balance for maximum tax savings while keeping the risk of an audit to a minimum? Conduct an annual reasonable compensation analysis and keep it on file with your tax documents.
How RCReports can help with reasonable compensation
RCReports offers reliable, reasonable compensation analysis backed by the largest database of wages in the United States. Each report details how your reasonable salary was determined, breaks down all of the tasks you do in your business, and how they contribute to your overall salary number. In addition, other sources are used in the calculation to build your defensible position in case of audit, including citations for court cases plus IRS fact sheets and methodologies. Lastly, reports are customized based on your location, the hours worked in your business, tasks performed, and even the proficiency of these tasks.
To learn more about RCReports and how you can get your own reasonable compensation analysis, click here.
This article was written by RCReports, OnPay’s partner that helps S Corps with quick and easy reasonable compensation analysis in just minutes.