One of the most frequent questions we receive is how profitability factors into a Reasonable Compensation calculation. Unfortunately, Reasonable Compensation has very little to do with the Profit or Loss of an S Corp, and everything to do with the S Corp’s Distributions.
So let’s clear up the confusion. Profitability and Distributions are not the same; they are separate and distinct events. Reasonable Compensation is not tied to Profit or Loss – it’s tied to Distributions. The IRS guidelines for Reasonable Compensation state: The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly. It does not mention profit or loss at all but instead talks about ‘amounts received’ by the shareholder. Therefore it does not matter whether or not the company is making or losing money; what matters is whether or not the S Corp owner is taking money (or other items of value) out of the S Corp. Let’s take a look at a couple examples so we can better understand the issue:
Example 1: Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2014 Stone Concrete had a net profit of $112,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $66,354. Scott would like to take out as much cash from Stone Concrete as he can. After consulting with his CPA Scott elects to take $90,000 out of Stone Concrete. Scott will receive Reasonable Compensation of $66,354 and a distribution of $23,646.
Example 2: Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2014 Stone Concrete had a net profit of $23,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $66,354. Scott would like to take out as much cash from Stone Concrete as he can. After consulting with his CPA Scott elects to take $30,000 out of Stone Concrete. Scott will receive Reasonable Compensation of $30,000 and a distribution of $0.
Example 3: Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2014 Stone Concrete had a net profit of $155,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $66,354. After consulting with his CPA Scott elects to take NO distribution from Stone Concrete. Scott will receive a Reasonable Compensation of $0 and a distribution of $0.
The last example becomes more complex because Reasonable Compensation issues can span multiple years, a scenario we will explore in the future.
