Strategies for determining reasonable compensation

As we talked about last month, the owner of an S Corporation needs to pay themselves a salary. This compensation must be reasonable. They are also allowed to take a distribution from their business. Distributions, within certain limits, are not taxable. So if you are the single owner of an S Corporation, how much should you pay yourself? The answer to this question is not straightforward, but in this month’s blog, I will give you some tips on figuring this out. 

First off, let’s back up just a bit and understand where the idea of “reasonable compensation” came from. As I mentioned last month, an S Corporation owner can pay themselves through a W-2 salary, shareholder distributions, or a combination of both. Prior to 2005, the IRS was primarily concerned with S Corp owners who paid themselves no salary and took all of their compensation as a distribution. 

After 2005, the IRS began pursuing S Corps who paid their owners only a small salary and then allowed them to take large distributions. Through these tax court cases, we got the concept of “reasonable compensation.” The idea is that the salary paid to the S Corp owner must be “reasonable” given the services they provide to the S Corp. 

So what are some ways we can determine what constitutes a “reasonable” salary?

Use industry salary guides

Many professional groups publish annual salary guides for their industry. A quick Google search can reveal several surveys and reports to begin figuring out what a reasonable salary is for your particular job. Salaries vary based on the number of years of experience, expertise, and even which part of the country you live in. A good salary guide will publish specific results for each of these areas. 

Consider the salary range

Chances are, you did not begin your working life as a self-employed person. You probably gained education and experience through an employer before you went out on your own. From being an employee, you probably also learned that salaries are not necessarily predetermined. They are very fluid and vary from person to person and company to company. In short, salaries are more accurately described in a range rather than one set number.

In determining reasonable compensation, you are allowed to choose the lower end of a salary range. It doesn't have to be the highest salary ever offered for your position, but it does need to represent appropriate compensation for your duties. 

Consider how much you’d ask for if you were applying for your job

If you, as an employer, were going to publish a job ad and look for someone to perform the duties you perform, how much would you offer that person? And the flip side of that, if you were an employee looking for your job, how much salary would you request during the hiring process? While you don’t have to choose the top dollar at the most prestigious company around, you do need to consider what a reasonable person would expect to be paid for the job duties you are performing. 

Must be able to look an auditor in the eye and sleep at night

So why does all this matter? Who’s going to know if I pay myself $20,000 or $200,000? Well, in September 2021, the Treasury Inspector General for Tax Administration (TIGTA), released its first report since 2012 on S Corp owner’s reasonable compensation. The IRS is increasing its efforts to address underreporting issues in regards to reasonable compensation. While the risk of an IRS audit is low, it is not nonexistent. I don’t know about you, but I want to do all I can to avoid an IRS audit, if at all possible. 

Need help? 

As you’re determining if filing as an S Corp is for you, I can help make sure your books are accurate and help you interpret what the information means for your future. Email me and we can discuss