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Expert Advice

Am I taking Reasonable Compensation From My Own S Corporation?

Upon incorporation of your business you created a new entity and you became an employee of that corporation.  Will the compensation you are paying yourself be considered reasonable in the eyes of the Internal Revenue Service (IRS)?  Have you taken the time to consider what your reasonable compensation should be?

The following is a fictional dialogue between a client and his accountant:

Client:
I have heard that I should be taking a wage or salary from my S corporation.  Taking a wage or salary from my business costs me 15.3% of the total in Social Security and Medicare taxes.   If I just take a shareholder distribution then I don’t need to pay those taxes.  Right?

Accountant:
The IRS requirement states that “Distributions and other payments by an S Corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation”.  Therefore, if the S Corporation distributes any monies to the shareholder regardless what it is called the payment must be examined to see if it is or should be re-characterized as part of the S Corporation shareholders’ reasonable compensation.

Client:
I know what I’ll do I’ll give myself a small salary, say $12,000.  Okay?

Accountant:
The IRS definition of reasonable compensation is “the value that would ordinarily be paid for like services by like enterprises under like circumstances”.  The key to determining reasonable compensation is determining what the shareholder-employee did for the corporation (What would you have to pay another individual to perform all the duties that you do currently).  One method is to break down the shareholders total hours into different categories of service then apply an applicable hourly rate to each category.  In past cases the IRS has been willing to limit total hours to 2080(full time employment).  The calculation of reasonable compensation per FS-2008(Watson vs. United States) does consider Education/training, Experience, Duties and responsibilities, Hourly time commitment and effort, Dividend history, Timing and manner of paying bonuses to key people, What comparable businesses pay for similar services,  written compensation agreements and use of a formula to determine compensation that is established and consistent.

Client:
My corporation couldn’t afford to pay me what I’m worth.  Do I still need to pay myself this “reasonable compensation” amount?

Accountant:
According to the IRS, reasonable compensation will never exceed the amount received by the shareholder directly or indirectly.  Therefore if the shareholder did not receive any non-wage distributions then the IRS cannot increase the compensation received.

Client:
If my corporation can’t pay me this year what happens?

Accountant:
As long as there were no other shareholder distributions then your reasonable compensation cannot be increased this year.  If however,  in the year following there are monies  available then your reasonable compensation needs to be reviewed and monies owed to you for reasonable compensation from the prior year may have to be included.

Client:
When my corporation was started I loaned it money.  Now I am just repaying the loan back to myself and can’t afford to pay myself a salary.  Is this a problem?

Accountant:
Repayment of a shareholder loan will not be considered or re-characterized as reasonable compensation as long as the loan agreement is in writing, interest is being charged, collateralized if necessary and the fixed repayment schedule is being followed.

Client:
My Dad is an officer of my corporation and helps out occasionally but I’ve never paid him.  Does he need to be paid reasonable compensation?

Accountant:
Officers in name only or who perform minor services are not considered employees for the purposes of the reasonable compensation rules.  These facts should be documented and notated in the minutes of the corporation.

Client:
I’ve calculated my reasonable compensation.  What is my next step?

Accountant:
As your accountant I should review the calculation with you and then the corporate minute book should be updated to include how the compensation was calculated

Client:
What can happen if I choose to ignore the reasonable compensation rules?

Accountant:
That is a very unwise decision.  Under Revenue Ruling 74-44 which applies to small businesses, the IRS can re-characterize shareholder distributions into compensation.  They perform the calculation which often results in a higher amount then your computation.  This results in payroll taxes due which could be subject to a 100% penalty under current law.  The re-characterization can cause disproportionate distributions if the S corporation has more than one shareholder and may lead to a revocation of the S Corporation status which can cause financial hardship.  Some examples of Red flags are zero or low compensation for the officer, low salary versus larger distributions, and profits compared to compensation

Reasonable compensation for S corporation shareholders can be a very complex subject.  The subject seems to be attracting the attention of the IRS.  With large penalties for non-compliance, possible revocation of the S corporation status both of which could cause the IRS to think that an audit of your business will be a revenue generating project.  If you have any thoughts or concerns regarding your S corporation please contact us here at Sedore & Company

“S Corporation Compensation and Medical Insurance Issues” IRS.Gov Internal Revenue Service
27 Apr. 2015. Web 09 Nov. 2015

Rowe, Daniel “Reasonable Compensation for S Corporation Shareholders”  The Tax Advisor. AICPA
1 Nov. 2013. Web 1 Nov. 2013

Nitti, Tony “Tax Geek Tuesday: Reasonable Compensation In The S Corporation Arena” Forbes
4 Feb. 2014

Johnson, Debra M. ”Reasonable salary for S corporation owners” Journal of Accountancy 1 May 2012
5 Nov 2015