July 10, 2023

Understanding ‘Reasonable Compensation’ for Business Owners: A Guide for Taxpayers

The concept of “reasonable compensation is a critical aspect for business owners, particularly for those involved in both S and C corporations. Today, let’s talk about the ‘reasonable compensation’ landscape for S corporations.

If you’re a shareholder/employee of an S corporation, it could be tempting to turn wage compensation into pass-through income to lessen payroll taxes. The real challenge lies in determining – “Is the salary justifiable?” According to tax guidelines (Rev. Rul. 74-44), any distributions paid instead of fair compensation are classified as wage compensation.

The IRS insists that S corporation owners take a reasonable salary due to the way that these types of businesses are taxed. S corporations are pass-through entities, meaning their income, losses, deductions, and credits pass through to their shareholders for federal tax purposes. The shareholders report this income or loss on their personal tax returns, where it’s subjected to ordinary income tax rates, but not payroll taxes (i.e., Social Security and Medicare taxes).

However, if the owner of an S corporation also performs services for the corporation (effectively acting as an employee), the IRS requires them to pay themselves a ‘reasonable’ salary for these services. This salary is subject to payroll taxes, just like any other employee’s salary.

The rule is in place to prevent S corporation owners from avoiding payroll taxes by taking all of their income from the corporation as pass-through distribution profits, rather than as a salary. For example, without this rule, an S corporation owner could pay themselves a tiny salary (or none at all) and take the rest of their income as a distribution, thereby avoiding substantial payroll taxes.

What constitutes ‘reasonable’ compensation can depend on many factors such as the nature of the business, the extent of the services provided by the owner, and what similar businesses pay for those services. If the IRS determines that an S corporation owner’s salary is unreasonably low compared to their distribution profits, it can reclassify some of those profits as wages, leading to back payroll taxes and penalties. Hence, it’s crucial to set a salary that accurately reflects the owner’s contribution to the business.

Remember, this rule applies only if you, as a shareholder, perform services for the S corporation. Non-active shareholders aren’t required to draw wage compensation. Despite clear guidelines, the compliance with ‘reasonable compensation’ often takes a backseat, resulting in potential losses to the public treasury, as highlighted in a recent report.

It’s essential for us to respect these regulations. Ignoring non-compliance can lead to hefty penalties. A fellow tax professional ended up settling a case for $34,500 due to such an oversight.

‘Reasonable compensation’ has implications on several aspects of your financial life:

  • Payroll Taxes: If we manage to reduce your wages as a shareholder, it could decrease overall payroll tax liabilities. However, if the wages drop below a ‘reasonable’ level, your S corporation could face payroll tax liabilities.
  • §199A Deduction: Overpaying wages might shrink the corporation’s qualified business income (QBI), potentially reducing your §199A deduction. But, in certain scenarios, an increase in wages could expand the §199A deduction.
  • Social Security Benefits: Regularly low wages might impact your retirement benefits, especially if the S corporation is your sole income source.
  • State Taxes: Paying too much in wages might reduce the income eligible for the state-level pass-through elective entity tax.
  • Retirement Contributions: If your maximum annual retirement contribution is linked to wage compensation, low wages could restrict your ability to defer income.
  • SECURE 2.0 Rule: According to SECURE Act 2.0 of 2022, overpaying your wages as a shareholder could affect your retirement contributions.

If the IRS determines that an S Corporation owner’s salary is unreasonably low, they can reclassify some or all of the owner’s distributions as wages. The consequences can be quite serious. The corporation could be required to pay unpaid payroll taxes, plus interest, and potentially face penalties. These assessments can be applied retroactively, leading to significant unexpected costs.

Furthermore, underpayment of salary can also have impacts on the owner’s personal financial situation. For example, it can limit the amount the owner can contribute to a retirement plan, which is often based on their salary. It could also reduce the amount of Social Security benefits the owner is eligible for upon retirement, as these benefits are calculated based on your earnings history.

Therefore, it’s very important for S Corporation owners to ensure they are taking a reasonable salary for their role and responsibilities, both to comply with IRS rules and to protect their own financial future.