IRS Calculation for S-corp Reasonable Compensation

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Introduction:

If you’re an owner of an S-Corp, one of the most crucial aspects of your tax strategy is determining what constitutes reasonable compensation for your work. While it may seem straightforward, the IRS calculation for S-Corp reasonable compensation is often a grey area that can lead to serious tax consequences if not handled properly.

When you’re the owner of an S-Corp, you’re required to pay yourself a reasonable salary if you’re actively working in the business. The IRS expects S-Corp owners to take a “reasonable compensation” for their labor, which is subject to payroll taxes. However, there is a common temptation among small business owners to pay themselves less salary and take larger distributions in order to reduce payroll tax liabilities. This strategy can be risky, and if the IRS deems your compensation unreasonable, you could face penalties and back taxes.

In this post, we’ll break down the IRS guidelines for calculating reasonable compensation for S-Corp owners, including the factors that influence this calculation, how to avoid penalties, and practical steps to ensure your salary is in compliance with IRS rules. Let’s dive into what you need to know.

Table of Contents:

  1. What is Reasonable Compensation for S-Corp Owners?
  2. Why is Reasonable Compensation Important?
  3. IRS Guidelines for S-Corp Reasonable Compensation
  4. How to Calculate Reasonable Compensation for Your S-Corp
  5. What Happens If You Don’t Pay Yourself a Reasonable Salary?
  6. Best Practices for Determining Your S-Corp Salary
  7. Common Mistakes to Avoid When Setting Your Salary
  8. Conclusion
  9. Frequently Asked Questions (FAQs)

What is Reasonable Compensation for S-Corp Owners?

In an S-Corp structure, the owner typically wears two hats: one as the shareholder and one as the employee. As an employee, the IRS requires you to pay yourself a reasonable salary for the work you perform for the business. This reasonable compensation must be reported as wages on your tax return and is subject to payroll taxes, including Social Security, Medicare, and unemployment taxes.

The challenge for many business owners is understanding what constitutes “reasonable” compensation. Unfortunately, the IRS doesn’t provide a clear formula or specific amount, leaving many owners wondering how to calculate it. The key is that the salary must be in line with what someone in a similar role would earn for similar work in the same geographical area.

Why is Reasonable Compensation Important?

Reasonable compensation is critical because the IRS pays close attention to how S-Corp owners distribute their income. If you underpay yourself on purpose in order to avoid paying payroll taxes (which apply only to salary and not to S-Corp distributions), the IRS may reclassify the distributions as wages and charge you for the unpaid payroll taxes. This could result in hefty penalties, interest, and back taxes.

The IRS’s primary concern is that owners are not underreporting their earnings to avoid payroll taxes. In 2016, the IRS began taking a stronger stance on the issue, auditing more S-Corps and scrutinizing how businesses set their owners’ salaries. This crackdown means it’s more important than ever to ensure your salary is reasonable and justifiable.

IRS Guidelines for S-Corp Reasonable Compensation

The IRS defines reasonable compensation as the amount that would typically be paid for similar services in the same industry, region, and size of the business. While the IRS does not offer a specific formula for calculating reasonable compensation, they do provide a set of factors to consider when determining what constitutes a fair salary.

Factors the IRS Considers:

  1. Training and Experience: The IRS considers the education, skills, and experience of the individual when determining reasonable compensation.
  2. Duties and Responsibilities: The complexity and nature of the work performed play a significant role in determining salary.
  3. Time and Effort Spent on the Business: The amount of time an owner spends managing, operating, and working in the business affects the level of salary.
  4. Comparable Salaries in the Industry: The IRS expects owners to pay themselves a salary comparable to what other individuals in similar businesses with similar duties earn. You can gather this information from salary surveys, industry reports, or compensation databases.
  5. The Company’s Size and Profits: Larger companies with more profits may justify a higher salary for the owner compared to smaller businesses with limited resources.
  6. Economic Conditions: The state of the economy, industry trends, and the financial health of your business also impact your reasonable compensation.

By considering these factors, you can more accurately determine what a reasonable salary is for your position within the company. Keep in mind that the IRS expects this compensation to be commensurate with the services rendered and in line with what a non-owner employee would earn for performing similar duties.

How to Calculate Reasonable Compensation for Your S-Corp

Factors to Consider

When calculating your reasonable compensation, it’s helpful to look at the following elements:

  • Industry Standards: Use salary data from reliable sources like the Bureau of Labor Statistics (BLS) or industry compensation surveys to determine what people in similar roles earn.
  • Job Description and Time Commitment: If you’re performing multiple roles in the company (such as a CEO, marketer, and salesperson), consider the compensation for each of those roles.
  • Business Profits: A business with higher profits can support a larger salary, while a struggling business might justify a lower compensation, but it should still be within a reasonable range.
  • Comparable Companies: Compare your business to others of similar size and in the same geographic area. You can find compensation data from trade organizations or online resources like PayScale and Glassdoor.

IRS Safe Harbor Guidelines

While there is no specific IRS formula for calculating reasonable compensation, there are some safe harbor guidelines that can help ensure compliance. One such example is the IRS’s safe harbor for S-Corp owners who take distributions instead of salary. If you take a salary that is at least equal to the median wage for a comparable position within your industry and region, this could help protect you if the IRS audits your compensation. This “safe harbor” method gives you more assurance that your compensation is reasonable.

However, relying on industry averages alone is not enough. You must ensure that the salary reflects both the market rate and your personal involvement in the business.

What Happens If You Don’t Pay Yourself a Reasonable Salary?

If you underpay yourself—or fail to pay yourself at all—the IRS may reclassify your distributions as wages and assess payroll taxes on those funds. This can lead to:

  • Penalties and Interest: The IRS can charge penalties for failing to pay the appropriate taxes on your salary. Interest on the unpaid taxes will accrue, increasing the amount you owe.
  • Increased Audit Risk: If the IRS suspects you are misclassifying your income, you may face an audit. This could result in further scrutiny of your business finances.
  • Tax Reclassification: If the IRS determines that your compensation was unreasonable, they may reclassify distributions as wages, leading to a significant tax liability.

Best Practices for Determining Your S-Corp Salary

To ensure your S-Corp salary complies with IRS guidelines, follow these best practices:

  1. Document Your Decision: Keep records of your salary determination process. This includes salary surveys, comparable wage data, and a breakdown of your duties within the company.
  2. Seek Professional Help: If you’re unsure about what constitutes a reasonable salary, consult a tax advisor or accountant who specializes in S-Corp taxation. They can help you navigate IRS rules and avoid mistakes.
  3. Pay Yourself Regularly: As an S-Corp owner, you should set up regular payroll just as you would for any other employee. Avoid taking large lump sums in distributions without paying yourself a reasonable salary first.
  4. Reassess Annually: As your business grows and your responsibilities increase, revisit your salary regularly. Don’t neglect adjusting your pay as your role in the company evolves.

Common Mistakes to Avoid When Setting Your Salary

  • Over- or Under-Paying Yourself: While it’s tempting to pay yourself a higher salary to reduce distributions or lower salary to avoid payroll taxes, both strategies can result in IRS penalties.
  • Ignoring the Importance of Documentation: Without proper documentation, the IRS may not accept your salary calculation if audited.
  • Failing to Adjust Compensation: As your business grows, your compensation should reflect the increased workload and business performance.

Conclusion

Determining reasonable compensation for your S-Corp is an essential part of running a compliant and tax-efficient business. While the IRS doesn’t offer a simple formula, by considering factors like industry standards, your role in the business, and economic conditions, you can arrive at a salary that reflects the work you’re doing and avoids costly tax penalties.

To stay on the safe side, it’s crucial to document your salary determination process and seek professional guidance if necessary. Remember that paying yourself a reasonable salary not only keeps you compliant with IRS rules but also strengthens the financial integrity of your S-Corp.

Frequently Asked Questions (FAQs)

1. Can I pay myself a salary that’s lower than industry standards?

While it’s not illegal to pay yourself a lower salary, the IRS may challenge it if they determine that it doesn’t align with what’s reasonable for your industry and role. This could result in penalties.

2. How often should I review my S-Corp salary?

You should review your salary at least annually, especially if your business or responsibilities have changed. Reassessing your compensation regularly helps ensure it remains in line with IRS guidelines.

3. Can I take distributions before paying myself a salary?

No. The IRS requires S-Corp owners to pay themselves a reasonable salary before taking any distributions. Distributions are not subject to payroll taxes, but wages are.

If you’re looking for ways to save on taxes and build wealth, our team of experienced CPAs and investment advisors can help. We specialize in strategies tailored to your unique financial situation, ensuring you maximize savings and keep more of what you earn. Don’t leave money on the table—reach out to us today at 970-949-1015 or hello@mckelveyinc.com to learn how we can guide you toward greater financial success.