What is reasonable compensation for S corporation owners?

If your business is taxed as an S corporation, the IRS has special rules for how owners are paid.

There are plenty of benefits S corporation owners, also called shareholders, receive that other kinds of business owners don’t. Namely, you don’t have to pay self-employment taxes on your distributions.

But there’s a catch. Owners can’t just pay themselves in distributions and avoid self-employment taxes entirely. S corp owners are required to pay themselves a salary that’s considered “reasonable compensation.”

So how do you determine what a reasonable compensation is? The IRS leaves that up to you. There’s no magic formula to calculate what constitutes a reasonable compensation. But there are a few factors and guidelines to keep in mind when determining your reasonable compensation.

What does reasonable compensation mean?

Reasonable compensation refers to paying S corp owners a salary — which is separate from taking distributions from your company. The IRS says you don’t have to take distributions, but you do have to make a salary.

By making a salary, that means you’re an employee of your own company and will receive a W-2. Your reasonable compensation and distributions are taxed differently from each other. Your salary is subject to a 15.3 percent self-employment tax and your federal income tax rate, while your distributions are not.

Determining your reasonable compensation amount is important because it determines how much — or how little — you’ll pay in self-employment taxes.

Self-employment taxes fund Medicare and Social Security. Because of that, the IRS will pay close attention to how much you designate as your reasonable compensation. In other types of business structures, like sole proprietorships and partnerships, owners pay self-employment taxes on their total share of profits.

How do I calculate reasonable compensation?

There’s no one-size-fits all answer to what your reasonable compensation should be. That answer depends on your role, your industry, your experience and a whole lot of other factors.

However, the IRS still offers some guidance to help you determine reasonable compensation so you’re not blindly guessing. The top three factors to consider, according to the IRS, are:

• The services of the owner
• The services of non-owner employees
• Capital and equipment

How can you practically apply those factors? Here are two easy methods:

• Look at similar salaries for similar jobs at similar companies. By basing your reasonable compensation off other people’s salaries in similar circumstances, that’s justifiable in the IRS’ eyes. You can view others in your industry and position’s average and median salaries on the U.S. Bureau of Labor Statistics website.
• Create your own formula for determining reasonable compensation. If you determine your reasonable compensation using a formula, it’s more likely to be OK with the IRS. Even if your formula isn’t perfect, the IRS likes to see that you have a methodology behind it.

Those aren’t the only ways to calculate reasonable compensation or things to consider. If you incorporate these other factors from the IRS says to consider, your reasonable compensation will probably be sufficient:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-owner employees
• Timing and manner of paying bonuses to key people
• Compensation agreements

Who’s required to receive reasonable compensation?

Reasonable compensation rules only apply to S corporation owners who provide “more than minor services” to the business. It doesn’t apply to employees if they’re not owners, and it doesn’t apply to owners if they don’t provide services.

It’s not all owners who provide services, either — the IRS only cares about owners and their family members who own more than 2 percent of the company.

What are “more than minor services?” The IRS doesn’t explicitly say, so it’s up to your discretion. If you decide that a shareholder only provides minor services to your business, then they’re exempt from receiving a salary.

Why do I have to pay reasonable compensation?

All these rules and regulations are to ensure that you don’t completely avoid paying taxes that fund Social Security, Medicare, and other programs that employment and self-employment taxes fund.

What some business owners will try to do is pay themselves a drastically low salary and receive most of their income through distributions to avoid as much self-employment tax as possible. Because those taxes are designated for important programs, the IRS will pay close attention to S corp owners.

You don’t need to abuse the benefits of owning an S corp to save money. If you try to abuse them to save money, you’ll fail regardless. The IRS can classify some of your distributions as your salary if they deem you paid below a reasonable compensation. So you’ll end up paying more in self-employment taxes and underpayment penalties. You’ll likely also have to endure the stress of a reasonable compensation audit.

The bottom line

S corp owners are paid differently than most other business owners. Instead of paying themselves solely through distributions, the IRS requires them to pay themselves a “reasonable compensation” in the form of a salary.

S corp distributions aren’t subject to self-employment taxes, which are used to pay for significant programs like Medicare and Social Security. However, reasonable compensation is subject to taxes. That’s why the IRS requires your compensation to be reasonable — so that you still contribute to Social Security and Medicare.

There’s no one right way to calculate reasonable compensation, according to the IRS. The best way to do it is by evaluating what people make for similar roles in similar industries. You can also create your own formula, as long as it takes into account these major factors from the IRS.

If you’re not careful about making sure your salary is reasonable, then the IRS can hit you with underpayment penalties. To avoid penalties and maximize your tax savings, schedule a free call with an advisor today for personalized advice on calculating reasonable compensation.