The Importance of Reasonable Compensation for S Corporation Owners
As more small business owners opt to elect S Corporation (S Corp) status to take advantage of tax benefits, one critical factor that often goes overlooked is reasonable compensation. Understanding and adhering to the Internal Revenue Service (IRS) guidelines on reasonable compensation is essential for S Corp owners to avoid costly penalties and ensure compliance.
What Is Reasonable Compensation?
Reasonable compensation refers to the salary or wages an S Corp owner pays themselves for the services they provide to the business. The IRS requires that this compensation be comparable to what a business would pay an employee for similar services in the same industry. In other words, S Corp owners must pay themselves a fair wage before taking distributions from business profits.
Why Does Reasonable Compensation Matter?
Many S Corp owners may be tempted to take most or all of their earnings as distributions rather than wages to minimize Social Security and Medicare tax obligations. However, this approach is risky and can trigger IRS scrutiny. If the IRS determines that an owner’s salary is unreasonably low, it has the authority to reclassify distributions as wages, subjecting the business to employment taxes, penalties, and interest.
Ensuring reasonable compensation protects S Corp owners from:
- IRS audits and reclassification of distributions as wages
- Unpaid employment taxes with accruing interest and penalties
- Legal consequences of tax evasion or misclassification
How Is Reasonable Compensation Taxed?
Wages paid to an S Corp owner are subject to payroll taxes, including Social Security and Medicare taxes (FICA). These taxes are split equally between the owner and the business. In addition, the business may be responsible for federal and state unemployment taxes. On the other hand, distributions taken from the business after reasonable compensation has been paid are not subject to these payroll taxes, offering potential tax savings.
Determining a Reasonable Salary
Unlike traditional employee salaries, there is no fixed formula for determining reasonable compensation. The IRS considers several factors, including:
- The financial condition of the business
- The owner’s job duties and responsibilities
- The number of hours worked
- Industry salary benchmarks for similar positions
- The owner’s qualifications, experience, and education
While some business owners use the 60/40 rule (allocating 60% of profits to wages and 40% to distributions) as a guideline, this method is not officially recognized by the IRS. Each business should assess its circumstances individually to determine fair compensation.
How to Pay Yourself as an S Corp Owner
To remain compliant, S Corp owners should set up a payroll system that withholds the appropriate employment and income taxes. Payments can be made on a biweekly, monthly, or quarterly basis, based on IRS payroll tax deposit schedules. The business must file IRS Form 941 for quarterly payroll tax returns and IRS Form 940 for federal unemployment tax reporting. At the end of the year, the owner must receive a W-2 just like any other employee.
Conclusion
While electing S Corporation status offers significant tax advantages, failing to pay reasonable compensation can lead to severe consequences. S Corp owners must carefully assess their earnings and pay themselves a fair salary that aligns with industry standards to remain in compliance with IRS regulations. By taking these steps, business owners can maximize their tax benefits while avoiding unnecessary legal and financial risks.
