Reasonable compensation – what is it?
Reasonable Compensation for Companies With S Corporation Status
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 for an S Corporation:
- Employee duties performed
- The volume of business handled
- The character of the job and the 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.
Reasonable Compensation for LLC Owners Electing C Corporation Status
Unlike S Corporations, where the IRS concerns itself with the owners not paying enough reasonable compensation, the opposite is true in LLCs filing as C Corporations. Because wages are a deductible expense for C Corporations, owners typically prefer to designate more profits as salary rather than dividends (which are not tax deductible). In C Corporations, the IRS looks out for excessive compensation as a disguise for dividends.
However, the IRS guidelines for reasonable compensation in a C Corporation are the same as in an S Corporation. You can feel secure by making sure you’re paying a fair amount for the work performed.
Article excerpts by Nellie Akalp
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