S Corps and Reasonable Compensation: What’s Really Reasonable?
Basics & Beyond™ offers many tax webinars to help you stay up-to-date on various topics. One of which is S corps and reasonable compensation. In the United States, corporations come in a variety of shapes and sizes. For many businesses, choosing to form a C corp versus an S corp is a huge decision, and a lot of thought goes into it. There are advantages and disadvantages to both forms of incorporation, and there a ton of variables to take into account when attempting to decide which one is right for a particular business.
That said, many small- and medium-sized businesses (SMBs) end up opting to form an S corporation rather than a C corp, due to the tax advantages that an S corp can confer.
Specifically, S corps act as pass through entities. This means that S corps aren’t taxed directly on their annual profits. Instead, these profits are “passed through” to the shareholders (owners) of the company. The profits are then taxed at the personal income tax rate of the shareholders. In contrast to this pass-through taxation structure, C corp profits are essentially taxed twice: once at the corporate tax rate, and then again after profits are distributed to shareholders.
There’s an important caveat here, however: S corp distributions aren’t subject to payroll taxes.
How can an S Corp reduce income tax liability?
Imagine the following scenario. A small business owner forms a sole proprietorship. Her business earns $100,000 in profit, and all of this income is included in her federal income tax filing. She’s taxed at her personal federal tax rate for this income. In addition to this, she’s liable for payroll taxes (Social Security and Medicare). When you’re employed by a company, your employer is required to pay half of your payroll taxes, while you pay the other half. The total payroll tax amount is 15.3%. Therefore, as an employee, 7.65% of your income will be due in the form of payroll tax. However, when you’re a self-employed sole proprietor, you must pay the so-called self-employment tax: you’re liable for the entire 15.3%. In this example, the sole proprietor would owe $15,300 in payroll taxes.
Now, imagine that this same person decided to form an S corporation instead. The S corp earns $100,000 in profit. However, rather than paying herself this amount as a salary, this business owner opts to distribute the entire profit. Because distributions aren’t subject to payroll tax, she no longer owes anything in payroll taxes. This amounts to a savings of $15,300.
Sound too good to be true? That’s because it is.
What is reasonable compensation?
As stated on the IRS website: “S corporations must pay reasonable compensation to a shareholder-employee” as a means of compensating that shareholder-employee for whatever services she performs for said S corporation. This reasonable compensation must be paid out before any additional profits are passed through the S corporation in the form of distributions.
In other words, it’s not possible for the owner of an S corporation to simply compensate themself in the form of distributions rather than salary, thus avoiding payroll taxes in their entirety.
The question, though, is this: what exactly does the IRS mean by “reasonable compensation?”
Reasonable compensation according to the IRS
The IRS spells this out in a rather complex fashion. Basically, here’s how they suggest you compute reasonable compensation.
- First, take into account where a company’s gross receipts — and, in turn, its profits — are coming from. Are they mostly derived from the labor of a shareholder-employee? Or, are they primarily coming from non-shareholder employees, capital, and equipment?
- If most of a company’s profits are derived from the services provided by non-shareholder employees in combination with the advantages of capital and equipment, then it’s sensible to distribute a significant portion of profits to a shareholder-employee rather than compensating them with a salary.
- However, if the majority of an S corporation’s profits are derived from the services provided by a shareholder-employee, then “most of the profit distribution should be allocated as compensation.”
While this is helpful in terms of the big picture, it still doesn’t provide us with a concrete sense of what portion of profits should be paid in the form of compensation versus through distributions.
Thoughts on computing reasonable compensation for an S corp shareholder-employee
One way of determining what a reasonable salary should look like for a shareholder-employee is to consider what you would pay a non-shareholder employee. When assessing this hypothetical salary, take all of the following into account:
- The employee’s duties and responsibilities
- Relevant experience and training, both on-the-job and otherwise
- The amount of time and energy that the employee devotes to the business
- History of dividends
- Payments being made to other non-shareholder employees
- Compensation agreements
- What other businesses of a similar size, age, and type pay for the same kinds of services
- Any and all bonuses associated with the position
- Any other related factors
As the Tax Adviser points out, a 2010 Iowa district court decision makes the situation relatively clear: it’s important to pay a shareholder-employee a reasonable salary. If you pay a shareholder-employee significantly less than what would be considered comparable for a similar company and opt instead to compensate that shareholder-employee in the form of distributions, you’re setting yourself up for an audit (and potentially legal action from the IRS).
How much compensation is reasonable for an S Corp?
At the end of the day, there’s no clear-cut answer to this question. While it would be ideal to be able to provide a specific percentage or number as a guideline, this simply isn’t possible. Every business is different, as is every industry.
However, by using the above guidelines, you can arrive at a reasonable compensation number for your particular situation. Keep in mind that what’s considered a reasonable salary may change over time. If a shareholder-owner starts contributing more in the form of time and expertise to an S corp, and their contribution is responsible for a significant portion of that S corp’s income, then their salary may need to be increased in order for it to continue to be considered “reasonable.”
If you’re a CPA, EA, or other tax professional who’s wondering how to advise your clients when it comes to reasonable compensation and S corporations, Basics & Beyond™ offers CEU webinars on this topic. To learn more about our webinars, click here.