What S Corporations Actually Need to Know About Reasonable Compensation

At a glance: 

• The main takeaway: S corporation shareholder-employees must pay themselves a reasonable compensation through a W-2 before taking any distributions from the business.  
• Impact on your business: If you are not collecting a reasonable wage but take distributions from the business, you could face back taxes and penalties from the IRS. 
• Next steps: Unsure whether filing as an S corporation is right for you. Aprio’s Tax advisors can review your responsibilities to determine reasonable compensation. 

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S corporation owners who also participate in the business as employees are faced with the question of what their salary should be. Some owners may think it is beneficial to not pay themselves any wages to avoid the self-employment taxes that would come with that wage, but the IRS requires that a reasonable compensation be paid.

What is Reasonable Compensation?

Reasonable compensation is the fair salary that would ordinarily be paid to a business owner, in this case an S corporation owner, to comply with IRS regulations. The IRS deems a reasonable wage as a flexible assessment based on all relevant facts and scenarios presented rather than a fixed amount, and regulations further state that the allowance for compensation shall not exceed what is determined to be reasonable.

It is important to fully understand how reasonable compensation relates to shareholder-employees to avoid any reclassifications of future payments to the shareholder.

How Does Reasonable Compensation Impact S Corporations?

The rules surrounding reasonable compensation affect S corporations when a shareholder is also an employee of the company and receives a W-2 wage. This occurs when shareholders in the S corporation provide services to the company beyond participating as a passive investor.

In this scenario, they are required to pay themselves a reasonable salary for the services provided, whether performed as an officer or an employee. There are many misconceptions and complexities that can arise when it comes to determining what is reasonable compensation and what is not. For example, simply using the maximum social security wages as a ceiling does not encompass the full scope of what the shareholder-employee contributes to the company.

Three Recognized Approaches to Reasonable Compensation

When determining whether compensation is reasonable, there are three generally accepted approaches — the cost approach, the market approach, and the independent investors test.

• The cost approach, which is utilized mostly when you have an officer that takes on a multitude of roles, breaks down what would be reasonable compensation within each role. Compensation of each position would be added together to determine the officer’s reasonable compensation.
• Market approach takes the fair market value of a nonowners compensation from within the same industry and compares them to what the officer was compensated.
• Independent investors test looks at the return on investment (ROI) for a company to determine if an independent investor would be satisfied with the ROI and not take issue with the amount that an officer is being compensated.

Why is Understanding Reasonable Compensation Important?

The main reason for determining reasonable compensation is to be able to correctly state the income and expenses on an S corporation tax return as well as properly classifying the income items for the individual shareholder. If a company decided to pay an officer a $1 million distribution with no W-2 wages for the current year in which they were an employee of the company, the zero W-2 wages would not be considered reasonable compensation and would need to be reclassified.

For example, the payments could be reclassified to $500,000 of W-2 wages and $500,000 of distributions. The IRS imposes this rule to ensure that officers of S corporations are not avoiding self-employment, social security, and Medicare taxes on the wages they earn. Conversely, if the entity was set up as a C corporation the attractive option would be to pay officers more than their worth to avoid double taxation.  

Demonstrating Compensatory Intent

IRS regulations state that “the test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services,” meaning that on top of the need for officer’s compensation to be reasonable it must also be compensation in nature and not a disguised dividend or distribution. Any amount determined to not be for the purchase of the officer’s services is not deductible as a salary.

The bottom line

Understanding reasonable compensation is important for owners of S corporations who are paid a salary to determine what their W-2 should say at the end of the year. If their salary doesn’t align with similar roles within their industry, it is likely that the amounts will need to be reclassified. Some owners may find it enticing to have zero wages to attempt to get around self-employment taxes, but the IRS is aware of this, which is the catalyst behind the reasonable compensation rules.

If you’re an S corporation owner, who also participates as an officer or employee, Aprio’s Tax Advisors can help you determine a fair reasonable compensation.

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