IRS Guidelines for “Reasonable Compensation” in an S Corporation

The IRS closely monitors S Corporations for owners taking unreasonably low salaries to avoid payroll taxes. According to the IRS, an S Corp owner-employee must receive “reasonable compensation” for the services they provide before taking any distributions or draws.

Here’s what the IRS considers when determining whether the compensation is “reasonable”:

Factors Influencing Reasonable Compensation

1. Job Role and Duties:
   • The type of work the owner performs is a primary factor. If the owner is actively involved in day-to-day operations, managing employees, handling clients, or working on business development, they are expected to receive compensation in line with their contributions.
2. Industry Standards:
   • The IRS looks at what other people in similar positions and industries are paid. For example, if a CEO in the same industry typically earns $100,000, the owner-operator of an S Corp performing similar duties should take a salary in that range.
3. Experience, Training, and Qualifications:
   • If the owner has specific qualifications or extensive experience, their compensation should reflect that. More experienced or qualified owners are expected to earn more compared to someone new to the field.
4. Time and Effort Spent:
   • If the owner is working full-time in the business, they should be paid more than someone working only part-time. The time and effort put into the business significantly affect what’s considered reasonable compensation.
5. Company Size and Revenue:
   • The size of the business and its revenue can impact the salary. For example, a small business with low revenue may justify a lower salary, while a larger, more profitable business would necessitate a higher salary for the owner-operator.
6. Profitability and Cash Flow:
   • While reasonable compensation is based on role and industry standards, the financial health of the business is also considered. If a business is struggling or not generating sufficient profits, it may justify a lower salary, though some salary should still be paid.

Common IRS Audit Red Flags for Compensation

1. Minimal or No Salary with Large Distributions:
   • Taking little to no salary while simultaneously taking large owner’s draws or distributions is a major red flag for the IRS. If the bulk of compensation comes through distributions, it’s likely to raise questions during an audit.
2. Salary Lower than Industry Norms:
   • Paying yourself far below the average salary for your industry or job type can be another trigger for the IRS. If most executives in your field make $100,000 but you’re paying yourself $20,000, it’s considered unreasonable unless properly justified.
3. Sudden Changes in Salary or Distributions:
   • Any abrupt drop in salary or a significant increase in owner’s draws without a legitimate business reason could be suspicious to the IRS.

Balancing Salary and Distributions

A common strategy is to pay yourself a salary that is within the range of what someone in your role would typically earn, and then take additional profits as distributions. Here’s how you can balance salary and distributions:

1. Establish a Baseline Salary:
   • Research industry salary data for your position and duties. This will serve as the baseline salary that you must pay yourself to stay in compliance with IRS rules.
2. Take Distributions after Salary:
   • Once your salary is set, you can distribute additional profits as draws. These draws are not subject to payroll taxes, which can reduce your overall tax burden, but the salary must come first.
3. Adjust Based on Company Performance:
   • If the business is thriving, you may be able to increase both your salary and distributions. In years when the business struggles, you might take a lower salary, but it should still be a reasonable figure for your role and contributions.
4. Document Your Salary Decision:
   • Keep detailed records of how you determined your salary. This might include industry research, comparisons to other similar businesses, or financial documents showing why a lower salary was necessary (e.g., low cash flow).

Penalties for Not Paying a Reasonable Salary

If the IRS determines that your salary was unreasonably low, they can reclassify distributions as wages and impose back taxes, interest, and penalties. These taxes would include both the employer and employee portions of Social Security and Medicare taxes that were avoided.

Safe Salary Ranges for Owner-Employees

• While there’s no official IRS formula, most tax advisors suggest that owners should aim to pay themselves at least 50% of their total income from the business as salary. For example, if you withdraw $150,000 from the business in total, at least $75,000 should be in the form of salary to be considered reasonable.

Conclusion

To remain compliant with the IRS, it’s essential to take a salary that reflects your role, industry, and business size while using owner’s draws strategically to reduce tax liability. Balancing these elements allows you to maximize tax efficiency while minimizing the risk of IRS penalties.