Owners of S Corporations have tax savings advantages that other entities don’t have. As an S Corp, you must pay income AND payroll taxes on wages to the owners, but cash distributions only have income tax implications. Over the years, there have been many S Corp owners who have taken advantage of the tax savings and have paid themselves unreasonably low wages and taken many large cash distributions. Reasonable compensation is the IRS’s way of making sure that as an S Corp owner, you are paying yourself a fair, living, taxable wage.
Reasonable compensation is defined by the IRS as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” Are you paying yourself enough in the eyes of the IRS? If you haven’t done research and calculations to come up with your salary, you most likely are not paying yourself in the way that you should be. The IRS can challenge you on the salary you are paying yourself if they don’t think it’s reasonable.
Let’s dig into why reasonable compensation is important, how to determine it, and how to have proof that your compensation is reasonable for the IRS should you ever be challenged.
Why Reasonable Compensation is Important
From a business planning perspective, we want to optimize what the compensation is on your W2 with the distributions you are taking out of the business. There are potential tax savings on the Medicare and Social Security (payroll) taxes when you can take distributions. For instance, if you want to take $100,000 from your business, do you need to pay yourself $100,000 by reasonable compensation? Or can you pay yourself $80,000 by reasonable compensation on your W2 and 20,000 through distributions? That $20,000 difference is a $3,000 potential tax savings on Medicare and Social Security wages.
At the same time, it is also important to make sure that you are paying yourself enough in W2 wages. If you are not paying yourself enough reasonable compensation, it could open you up to an IRS audit. The IRS wants to make sure that you are paying yourself reasonable compensation and not just taking large distributions and low W2 wages to avoid paying payroll taxes.
How to Determine Reasonable Compensation
A lot of information goes into considering reasonable compensation because, let's face it, as a business owner, you are not ONLY doing what your business is known for, you are also doing HR, bookkeeping, administration, cleaning, etc. So how do you determine how much you should be paying yourself?
There are three different ways you can do it but essentially we do what is called replacement cost. That is a composite of all the job functions performed for your business so that you come up with a composite compensation number that would be reasonable in the eyes of the IRS to use as your compensation. Then any additional money can be taken out of the business as distributions.
Some of the things that go into determining reasonable compensation are things like:
Your training, education, and experience
Your duties and responsibilities in the company
Location of your business
The time and effort you have devoted to your business
If there are any compensation agreements in place
Any history of distribution payments to any non-shareholder employees that you have in your business
Timing and manner of payment for bonuses to other employees
What the comparable compensation would be of a business that is similar to yours if you were not paying yourself
All of this goes into this formula and this calculation that's rather complex. It comes up with a composite number that it spits out with what your reasonable compensation should be. This is a really good tool to use and to have in any kind of IRS defense if they were to come to you and say that you're not paying yourself enough.
The Burden of Proof
If challenged by the IRS, you must be able to show that compensation is reasonable. This is why it is important to develop a consistent year to year policy for your business to follow when determining reasonable compensation. Each year after determining reasonable compensation, you must add all documentation, reasoning, and all other notes to your corporate minutes. During an audit, the IRS will ask for your corporate minutes and they will want to see the reasoning behind your reasonable compensation in there.
There are actually many business owners, who when we talk, have no clue about reasonable compensation as a prior accountant has never had the discussion with them, which is why I am passionate about educating and asking a lot of questions. 2020 was altogether difficult, but it most definitely shed much light on issues small businesses face with compensation. The PPP Loan process was difficult for those who didn’t have proper compensation set up, or for S Corps who were not paying a reasonable compensation through W2 wages (perhaps too low and therefore didn’t qualify for as large of a loan as expected), etc. Did this happen to you or someone you know?
Reasonable compensation can be rather complex. That’s why we offer reasonable compensation reports as a part of our tax return services for our clients who have an S Corp. Beginning this year, we are offering a new package called Cultivate. This package is perfect for the business that is on the verge of growth. This package includes annual tax returns as well as ongoing communication with our team throughout the year. It would be a great option for S Corps who are not in need of a bookkeeper yet but need their tax returns done, an annual reasonable compensation report, and access to our team with the many questions that come with a growing business. Schedule a discovery call with us to learn more about Cultivate and other ways that we can help you make sure you are paying yourself enough.