Understanding Reasonable Compensation for S Corporation Owners

Sandra Lanier-Thomas

Understanding Reasonable Compensation for S Corporation Owners

 

As a shareholder-employee of an S corporation, you are legally required to pay yourself a "reasonable compensation" before taking any distributions from your business. But what exactly is considered reasonable? This is where a Reasonable Compensation Analysis becomes essential – a service I now offer to help S corporation owners stay compliant and avoid costly penalties.

Why Reasonable Compensation Matters

The IRS closely monitors how S corporation owners divide their income between wages and distributions. Why? Some business owners try to reduce their tax burden by paying themselves a low salary while taking larger profit distributions — avoiding payroll taxes on that income. The IRS is cracking down on this practice, and non-compliance can lead to penalties, back taxes, and even revocation of your S corporation status.

A reasonable compensation figure isn’t just about what you want to earn — it’s based on what someone in a similar role at a similar business in your area would be paid for the work performed. The challenge for many S corporation owners is that they wear multiple hats in their business, serving as bookkeepers, marketers, customer service reps, and more. This makes determining the correct salary a complex task.

How a Reasonable Compensation Analysis Works

To accurately determine your reasonable compensation, an analysis takes into account:

  • The various roles you perform in your business
  • The amount of time you dedicate to each role
  • Industry standards for each job function
  • Geographic location and regional salary data

A specialized tool analyzes this data, producing a documented, defensible compensation figure that withstands IRS scrutiny. This protects you from costly audits and penalties while ensuring compliance with tax laws.

Factors the IRS Considers When Evaluating Compensation

There is no single formula to calculate reasonable compensation, but the IRS and courts consider various factors, including:

  • Your training, experience, and responsibilities
  • The financial health of your business
  • Time and effort devoted to the company
  • Salaries paid to non-owner employees
  • Industry-specific salary data from sources like the Bureau of Labor Statistics
  • Compensation agreements or bonus structures

Some business owners mistakenly use the "60/40 rule" (where 60% of income is taken as wages and 40% as distributions), but this is not an IRS-approved method and can still trigger an audit if not backed by real data.

Who Needs a Reasonable Compensation Analysis?

If you are an S corporation owner, you should complete a reasonable compensation analysis annually to ensure compliance with IRS guidelines. This service is especially beneficial for:

  • New S corporation owners unsure of how to set their salary
  • Business owners with multiple job roles
  • S corporations undergoing IRS audits or financial reviews
  • Accountants and tax preparers who need to provide documentation for their clients

Avoiding IRS Penalties

Not taking a reasonable salary (or underpaying yourself) can lead to significant financial consequences, including:

  • Reclassification of distributions as wages, resulting in back taxes, penalties, and interest
  • Fines for misreporting employment taxes
  • Possible lawsuits for failing to act in the best interest of the business and stakeholders
  • Potential revocation of your S corporation status

By using an IRS-approved method, sourcing unbiased data, and maintaining detailed records, you ensure that your salary aligns with tax regulations and withstands IRS scrutiny.

Additional Considerations for S Corporation Owners

  • Medical Insurance Premiums: If you own more than 2% of an S corporation, your company-paid health insurance must be included as wages on your W-2 (though it is not subject to Social Security and Medicare taxes).
  • Payroll Tax Obligations: S corporation owners who provide services to their business are employees and must have federal income tax, Social Security, and Medicare taxes withheld from their wages. Taking only distributions and not paying yourself a salary is a red flag for an IRS audit.

Get a Professional Analysis

I now offer Reasonable Compensation Analysis services to help S corporation owners determine fair and defensible salaries. This service is available remotely, meaning I can assist business owners across the U.S. If you’re unsure whether your current salary meets IRS guidelines, I can provide the documentation and guidance you need.

Don’t wait until an IRS audit puts your business at risk — schedule your Reasonable Compensation Analysis today!