What is “Reasonable Compensation”

Reasonable compensation is a critical concept for business owners, particularly those operating as S-Corporations or C-Corporations. The term refers to the amount of salary a business owner should pay themselves that would be considered “reasonable” by the IRS based on their duties, responsibilities, and industry standards. This concept carries significant tax implications and is frequently scrutinized during IRS audits.

Why Reasonable Compensation Matters

For S-Corporation owners, reasonable compensation is especially important. Many S-Corp shareholders try to minimize their salary to reduce payroll taxes, instead taking larger distributions that aren’t subject to self-employment taxes. However, the IRS requires S-Corp owners who provide services to their business to take a reasonable salary before distributions.

C-Corporation owners face a different challenge. They may be tempted to set extremely high salaries to reduce corporate profits (and thus corporate taxes), effectively converting corporate income into personal income. The IRS watches for this as well, ensuring compensation is truly reasonable for the work performed.

Payroll vs. Draws: Understanding the Difference

A crucial aspect of reasonable compensation is that it must be processed through formal payroll, not taken as draws or owner payments. This distinction is vital for proper tax compliance:

Payroll Compensation:

• Must be run through a legitimate payroll system
• Requires withholding of federal, state, and local taxes
• Includes FICA taxes (Social Security and Medicare)
• Generates proper tax forms (W-2s) and payroll tax returns
• Creates an official employment relationship between you and your company

Draws or Owner Payments:

• Do not satisfy the reasonable compensation requirement
• Don’t include proper tax withholding
• May trigger IRS scrutiny and potential penalties
• Cannot replace proper salary payments
• Are considered distributions, not compensation for services

Business owners must understand that simply writing themselves checks or transferring funds from the business account to their personal account doesn’t constitute reasonable compensation. The IRS specifically looks for formal payroll processing with appropriate tax withholding as evidence of legitimate compensation.

Determining Reasonable Compensation

The IRS doesn’t provide a specific formula for calculating reasonable compensation, but they consider several factors when evaluating whether compensation is reasonable:

• Training, experience, and education of the employee
• Duties and responsibilities within the company
• Time and effort devoted to the business
• Dividend history of the company
• Compensation agreements and payment history
• Comparable compensation for similar positions in similar companies
• The size and complexity of the business

Consequences of Unreasonable Compensation

When compensation isn’t reasonable, businesses face potential consequences:

For S-Corps paying too little salary:

• The IRS may reclassify distributions as wages
• This triggers additional payroll taxes, penalties, and interest
• Back taxes can accumulate quickly, creating significant liability

For C-Corps paying excessive salaries:

• The IRS may recharacterize part of the salary as dividends
• This creates double taxation issues, as the corporation loses the deduction
• Penalties and interest may apply to underpaid corporate taxes

Best Practices for Setting Reasonable Compensation

To establish defensible reasonable compensation:

1. Document your methodology: Keep records of how you determined compensation levels.
2. Research comparable positions: Gather data on what similar businesses pay for comparable roles.
3. Consider all factors: Account for experience, responsibilities, business size, and industry norms.
4. Maintain consistency: Avoid dramatic fluctuations in salary that correlate with business performance.
5. Separate business and personal expenses: Don’t try to compensate for personal expenses through salary.

Industry Tools and Resources

Several resources can help determine reasonable compensation:

• RCReports and similar services provide compensation analysis tools
• Bureau of Labor Statistics offers wage data by occupation and location
• Industry associations often publish salary surveys
• Professional compensation consultants can provide expert guidance

S-Corporation Specific Considerations

S-Corporation owners must be particularly vigilant about reasonable compensation. While the pass-through taxation benefits of an S-Corp are valuable, they come with this significant compliance requirement. The temptation to take minimal salary and larger distributions to avoid payroll taxes is precisely what the IRS looks for during audits.

When setting S-Corp compensation, consider:

• Your active role and time commitment to the business
• The percentage of business revenue attributable to your personal services
• What you would pay someone else to do your job
• The financial condition of your company

C-Corporation Specific Considerations

For C-Corporation owners, reasonable compensation issues typically arise when trying to minimize corporate-level taxation. Since C-Corps face potential double taxation (corporate tax plus personal tax on dividends), owners may try to extract money as salary instead of dividends.

When setting C-Corp compensation, consider:

• The corporation’s overall profitability
• The proportion of corporate profits paid as compensation
• Compensation history and past dividend patterns
• Industry norms for similar-sized businesses

The Bottom Line

Reasonable compensation isn’t just a tax compliance issue—it’s a fundamental business practice that reflects the true value of services provided to the company. While tax considerations certainly play a role, the underlying concept is about fairness and accuracy in compensating business owners for their work.

Business owners should work with qualified tax professionals to establish and document reasonable compensation practices that will withstand IRS scrutiny while appropriately balancing tax efficiency with compliance requirements.

By understanding and implementing proper reasonable compensation strategies, business owners can protect themselves from costly audits while ensuring their business structure operates as intended.

Need Help with Reasonable Compensation? Contact Level Accounting and Advisory

Navigating reasonable compensation requirements can be complex and intimidating for business owners. At Level Accounting and Advisory, we specialize in helping S-Corporation and C-Corporation owners establish defensible reasonable compensation practices that satisfy IRS requirements while optimizing tax efficiency.

Our team of experienced professionals can help you:

• Determine appropriate compensation levels based on industry standards
• Set up proper payroll systems and processes
• Document your compensation methodology
• Prepare for potential IRS inquiries
• Create a comprehensive tax strategy that incorporates reasonable compensation

Don’t risk costly penalties or tax issues. Contact Level Accounting and Advisory today to ensure your business compensation practices are both compliant and optimized for your specific situation.