What is reasonable compensation when dealing with Subchapter S Corporations?

Trying to determine a reasonable salary in your Subchapter S corporation? Reasonable compensation refers to the amount of compensation that a shareholder-employee of an S corporation should receive for services rendered to the corporation.

The IRS often scrutinizes S corporations to ensure that shareholders who are also employees are not underpaid (salary) to avoid paying employment taxes. Instead, they may be paid through distributions, which aren’t subject to employment taxes. The dilemma is – What is the magic number?

Key Points on Reasonable Compensation:

• • Definition: Reasonable compensation in Subchapter S entities is the salary that an employee would typically receive for the work they perform for the company. It considers their duties, experience, and industry standards. It’s the fair market value for the work performed, based on comparable positions in the marketplace.

• • Why It Matters: The IRS requires S corporations to pay shareholder-employees reasonable compensation to ensure that income isn’t classified as distributions, which are not subject to payroll taxes. If a shareholder-employee receives little salary and instead takes larger distributions, the IRS may reclassify some of the distributions as salary, which is subject to payroll taxes. This helps prevent tax avoidance.

• • Theoretically – How It’s Determined: The IRS doesn’t have a precise formula for determining reasonable compensation in S corporations. Several factors are used for assessment:
    1. Role and Responsibilities: The nature and complexity of the work performed. Larger, more complex roles may warrant higher compensation.
    2. Experience and Skills: The shareholder’s level of education, experience, and skill.
    3. Time Devoted to the Business: The more time the shareholder spends working for the business, the higher the compensation should be.
    4. Comparison to Industry Standards: What similar businesses in the same industry and geographic area pay for similar positions.
    5. Company Size: Larger companies may have higher compensation levels due to the size of the operations.
    6. Company Profitability: The ability of the company to pay salary based on its earnings.
    7. Prior years What has been the compensation historically?

• • Methods of Determining Compensation:
    1. Industry Surveys: Using salary surveys or industry benchmarks for similar roles in similar-sized businesses.
    2. Third-party Valuations: Hiring a compensation consultant or expert to determine the appropriate salary.
    3. Comparable Positions: Reviewing compensation for similar jobs within the same geographic region, industry, and company size.

• • Documentation: To avoid IRS scrutiny, it’s important for S corporations to maintain documentation supporting the salary paid to shareholder-employees. This includes salary surveys, compensation studies, or other data that justify the level of compensation.

Example:

Imagine an S Corporation where a shareholder-employee performs management duties, but the company is small and not highly profitable. The owner might earn $50,000 as a reasonable compensation for their management role, based on industry standards, but if the company generates significant profits, it might also distribute additional earnings to the shareholder, which would not be subject to payroll taxes.

If the company paid $5,000 annually as salary but made significant profits and distributed $100,000 as dividends, the IRS could question whether the $5,000 is a reasonable amount and might reclassify part of the distribution as salary, subjecting it to employment taxes.

Conclusion:

Reasonable compensation in the context of an S Corporation is the salary that reflects the fair market value of the services provided by the shareholder-employee. It should be determined based on factors such as the individual’s role, experience, and industry standards. Ensuring the compensation is reasonable is crucial to avoid IRS penalties and ensure compliance with tax rules for S corporations.