By Paul S. Hamann & Jack Salewski, CPA
“Hey – I’m worth more than that “is a phrase S Corp and Small Business Owners express quite frequently after researching their Reasonable Compensation figure. Why? – Because most S Corp and Small Business Owners don’t understand what Reasonable Compensation is. They mistakenly equate Reasonable Compensation with their dedication and commitment to their business.
They factor in all the blood sweat and tears their business required from them to get off the ground, for the 80+ hour work weeks, and the personal and financial sacrifices they have made along the way to ensure their business succeeds. How can anyone possibly put a number on all of that! Well, luckily we don’t need to.
The IRS guidelines and courts have defined Reasonable Compensation as the amount an S Corp owner could expect to pay another individual in exchange for the services provided by the owner. This ‘other’ individual is a hypothetical replacement for the S Corp owner. To determine a salary for Mr./Ms. Hypothetical we need to build a custom job profile that matches the S Corp owners’ many duties and responsibilities. Then weigh the duties and responsibilities accordingly and calculate an hourly rate.
Why calculate an hourly rate? Two reasons: If you work less than 40 hours per week multiply by the actual number of hours worked. If you work 40+ hours per week you only need to multiply by 40 because the courts have defined full time, year-round employment as 2,080 hours per year, or 40 hours per week. So we don’t take into consideration all of the 60, 80, or 100 hour work weeks. We also don’t need to value the dedication, commitment, sacrifice, blood, sweat, and tears the S Corp owner provided to their business.
In the end, your Reasonable Compensation figure is simply an estimate of what it would cost to hire a hypothetical replacement for yourself; not the sum of your life’s work. The silver lining is you only pay employment taxes on your Reasonable Compensation figure, everything else you take out of your company as distribution departs your S Corp without incurring employment taxes.
So remember when your tax or financial advisor helps you determine your Reasonable Compensation figure and it seems low, they aren’t making a judgment on your worth to your business. They are simply following IRS and court guidelines, ensuring you are paying the least amount of tax legally owed, and not a penny more.