What S Corp Owners Should Know About the Reasonable Compensation Requirement

business owner giving a presentation about reasonable compensation requirments to board members

For an S Corporation, staying viable means continually evaluating the reasonable compensation requirement. Taking distributions from your company without paying reasonable compensation to all eligible shareholders can land you in hot water with the IRS. Below, we discuss more about assessing reasonable compensation for your S Corp and how RCReports can help you maintain compliance.

What is Reasonable Compensation?

Corporations and LLCs are formed under state law, but can’t be treated as an S Corporation until they make the election with the IRS by filing form 2553. Once the election is made, the organization is treated as an S Corp for tax purposes while still retaining its corporate or LLC status for state law purposes.  Making the S-election for a corporation keeps the owner’s assets separate from company debts (and the risk of lawsuits) while avoiding double taxation.

To file for the S Corp tax election, companies formed as an LLC or C Corp must be: (1) a domestic corporation; (2) with only one class of stock; (3) with no more than 100 shareholders who are U.S. citizens or resident aliens; and (4) with all shareholders agreeing to the S Corp election 1.

Once this election is made, the S Corp passes income, losses, deductions, and credits through to the shareholders; shareholders report the income (and losses subject to limitations) on their personal income tax returns, eliminating dividends and the tax on them, and allowing shareholders to manage their payroll tax liabilities often resulting in less overall tax than a C Corporation would pay. 

These benefits come with a cost; shareholders who provide services to the company must receive reasonable compensation. Business owners can’t just divide salaries and shareholder distributions to reduce payroll taxes; compensation must be reasonable (i.e., not too low or too high) to avoid IRS scrutiny 2.

When is Reasonable Compensation Required?

S Corporations are required to pay a reasonable compensation to a shareholder-employee for the services provided to the corporation before non-wage distributions can be made to the shareholder-employee. The amount of reasonable compensation paid to the shareholder-employee will never exceed the amount received by the shareholder either directly or indirectly. 

Business owner presents reasonable compensation requiremnts on a tablet to board members

However, this requirement doesn’t come into play for every S Corp. You’ll need to pay reasonable compensation only if you (and/or other shareholders) perform service for the S Corp and take distributions from the S Corp’s profits. If you’re not taking distributions, there is no requirement to take reasonable compensation 3.

This should come as a relief to many fledgling S Corps; it means that if your business isn’t yet earning enough to begin paying competitive salaries, you’re still in compliance.

On the other hand, if you are taking distributions from profit and aren’t paying reasonable compensation to all shareholder employees who provide services to the business, you are not in compliance and you could incur major IRS penalties. If a subsequent audit re-characterizes your distribution as salary, taxes, penalty, and interest can typically be significantly higher than the original tax that would have been owed 4.

What is a Reasonable Salary for an S Corp?

The IRS defines “reasonable compensation” as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” 5 In other words, if your S Corporations were another company, hiring someone off the street, what would it pay for these services?

The reasonableness of compensation depends on all the relevant facts and circumstances. Some of these factors include:

  • The duties the employee performs
  • The volume of business handled
  • The job type and level of responsibility
  • The complexity of the business
  • The amount of time required to do the job
  • The employee’s ability and achievements
  • The company’s compensation policy for all employees
  • The shareholder’s individual salary history
  • The amount that comparable businesses pay for similar services

If you’re not sure what reasonable compensation might look like, the U.S. Bureau of Labor Statistics can provide a good start on wage data. You can look at wage information broken down by industry, job type, years of experience.

RCReports also provides reasonable compensation calculations and reports. What’s more, we can assist in the event of an IRS audit, providing support and data for your calculated compensation. It is important to note that the best time to generate this data is now, not after notice you are being audited.  

Who is Required to Have Reasonable Compensation in an S Corp?

Any owners, officers, and shareholders who provide services to the S Corp) must be paid reasonable compensation in the form of wages. These wages will be subject to federal payroll taxes (including FICA and Medicare) both withheld from the employee and paid by the company.

board meeting discussing reasonable compensation

We have discussed the recharacterization of distributions as wages, but there are other things the IRS can recharacterize even if reasonable compensation is paid.  For example, if a shareholder owns real estate that is leased to their own S Corporation the IRS will look to make sure the lease is at fair market value (FMV).  If it’s not the IRS can reclassify it in one of two ways.  First, they could choose to treat it as additional wages resulting in overdue payroll taxes, penalties and interest.  Second, they could argue it was a disguised distribution resulting in less rent expense—and higher income.  If the rent is below FMV it could be reclassified as a capital contribution, again, lowering the deduction for rent and increasing income.  

As you can see, the determination of reasonable compensation is a highly case-specific one. Don’t leave it up to guesswork. RCReports offers accounting professionals comprehensive reports on reasonable compensation for shareholder-employees, customized to suit your clients’ specific business needs. Visit our website to explore the range of services RCReports provides or request a demo today to see how we can streamline your compensation analysis.

 References

1. Internal Revenue Service. (2021, January 12). Instructions for Form 2553

https://www.irs.gov/instructions/i2553 

2. Internal Revenue Service. (2023, June 26). S Corporation Compensation and 

Medical Insurance Issues. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues

The instructions to the Form 1120-S, U.S. Income Tax Return for an S Corporation, state ‘Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.’

The IRS has the authority to reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes). Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which are subject to employment taxes.”

3. Internal Revenue Service. (2023, June 26). S Corporation Compensation and 

Medical Insurance Issues. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues

“S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.”

4.  Kirkland, S. (2013, September 1). Preventing a challenge to (un)reasonable 

compensation. Journal of Accountancy. https://www.journalofaccountancy.com/issues/2013/sep/20137412.html 

“S corporations are audited to determine whether they have underpaid their shareholder-employees. These shareholders may have set their own pay levels unreasonably low and simultaneously increased their profit distributions. Since compensation is subject to payroll taxes, but distributions are not, some tax savings can be realized by simply reducing a shareholder’s compensation and increasing his or her distributions.”

5. Internal Revenue Service. (2023a, June 7). Exempt Organization Annual 

Reporting Requirements: Meaning of “Reasonable” Compensation. https://www.irs.gov/charities-non-profits/exempt-organization-annual-reporting-requirements-meaning-of-reasonable-compensation 

“Reasonable compensation is the value that would ordinarily be paid for 

like services by like enterprises under like circumstances. Reasonableness is determined based on all the facts and circumstances.”

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