Reasonable Compensation for S Corps

Reasonable Compensation for S Corps is something the IRS began looking at for corporation compliance back in 2005. The IRS is attempting to penalize shareholders who receive inadequate wage compensation for their role. They have conducted a study and gathered information on this matter.

The IRS will make a determination on what reasonable compensation should be for the individual officers. The problem is that there hasn’t been a concrete method in place to make the determination. Taxpayers are unsure about how much reasonable compensation to pay to avoid a significant penalty.

The IRS makes it clear that a shareholder employee of an S-Corp must be paid a reasonable compensation for the services that the individual provides. These distributions will be treated as wages and employment taxes need to be paid.

Any distribution taken from the S-Corp must be taken as reasonable compensation wages until the required amount has been met. After meeting the requirement, non-wage distributions may be taken and only income tax would be paid.

A fair wage for the level of work provided is what would be considered reasonable compensation. Reasonable compensation according to the IRS Code: Section 162-7(b)(3) is, “reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances.”

If you do not receive any money or property directly or indirectly from the corporation, then you are not required to take reasonable compensation.

If you make a contribution to the corporation and then later take a distribution without taking reasonable compensation, the distribution could be considered taxable wages and employment taxes would be assessed along with a penalty for failure to file the employment tax return on time.

Things to consider when working out a reasonable compensation

  • Level of education, training, and on job experience
  • Various roles and responsibilities, value of each role, and percentage of time spent on each role
  • Actual time and effort performing various roles
  • What is comparable pay for similar responsibilities

 An example of determining Reasonable Compensation for business owner: