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What Is Reasonable Compensation for an S Corporation?

April 28, 2022

If you’re considering taking an S Corporation election, it’s important that you review what obligations are involved in keeping an S Corporation viable. An important part of this review includes an evaluation of the reasonable compensation requirement.

Choosing to be an S Corporation can benefit many corporations because it allows the owners to save on payroll taxes by dividing business income into salaries and shareholder distributions. Owners only need to pay payroll taxes on wages and not on shareholder distributions, saving them money.

However, because some business owners may divide salaries and distributions disproportionately, the IRS keeps a close eye on an S Corp’s dividend distributions to make sure businesses aren’t attempting to avoid paying payroll taxes. So, paying owners/shareholders reasonable compensation can help your company stay on the right side of the IRS.

The Reasonable Compensation Factor

To dissuade business owners from hiding wages behind distributions to avoid paying payroll taxes, the IRS requires S Corporation owners to pay “reasonable compensation” to each shareholder/employee in exchange for any services given by the shareholder/employee. As defined by the IRS, “reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances.” In the eyes of the IRS, shareholders providing anything more than money to the company are considered employees—employees who must be paid wages comparable to salaries paid for similar services in similar industries.

The IRS suggests taking into consideration the following aspects when defining reasonable wages:

  • Employee duties performed

  • The volume of business handled

  • The character of the job and amount of responsibility

  • Complexities of your business

  • Time required to do the job

  • Cost of living in the area

  • Ability and achievements of the individual employee performing the service

  • Pay compared to the business’s gross and net income, as well as with distributions to shareholders if the company is a corporation

  • Your policy regarding wages for all employees

  • The history of salaries for each employee

You can also check the U.S. Bureau of Labor Statistics for comprehensive wage data searchable by occupation nationwide and comparable wages by state, region, and city.

S Corporation owners, officers, and shareholders working for and providing even minimal services to the company are required to receive wages. Therefore, payroll taxes, including FICA, FUTA, and federal income tax withholding, must be paid for all employees. To determine reasonableness, the IRS scrutinizes the S Corp’s gross receipts and then establishes what tasks the owner/shareholder performed to help generate gross income.

We have performed “reasonable compensation” studies for clients who are concerned about their payroll policies and whether they are in danger of IRS attack due to their payroll policies for officer/shareholders.  If you are concerned about your polcies, please contact us to learn more about this service.