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Understanding Reasonable Compensation in S Corporations

Understanding Reasonable Compensation in S Corporations

December 02, 2023

S corporations are a potent tool for small businesses, offering efficient management and reduced payroll taxes on profits. Yet, within this advantageous structure lies a crucial element: reasonable compensation. While business owners can avoid payroll taxes on distributions when organized as an S corporation, a reasonable wage is necessary for shareholder-employees.

 A qualified tax planner offers invaluable insights into matters of reasonable compensation, ensuring compliance with IRS guidelines and facilitating a comprehensive understanding of reasonable compensation frameworks. Their expertise can mitigate risks, prevent costly errors, and strategize effectively, aligning compensation practices with the regulatory standards that we go into below.

WHAT IS AN S CORPORATION?

 S corporations pass corporate income, losses, deductions, and credits to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are then assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on corporate income.

To qualify for S corporation status, one must:

  • Be a domestic corporation;
  • Have only allowable shareholders
    • May be individuals, certain trusts, and estates and
    • May not be partnerships, corporations, or non-resident alien shareholders.
  • Have no more than 100 shareholders.
  • Have only one class of stock.
  • Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).

To become an S corporation, the corporation must submit Form 2553, Election by aSmall Business Corporation, signed by all the shareholders.

THE SIGNIFICANCE OF REASONABLE COMPENSATION

In S corporations, shareholder-employees must receive a fair wage. It's not just a matter of fairness; it's a legal requirement. Lowering wages to minimize payroll taxes might seem tempting. Still, the IRS closely monitors this practice and can adjust wages to reflect reasonable compensation to ensure accurate tax submissions and prevent system abuse. This extends not only to shareholder-employees but also to family members who are paid for services rendered.

DEBUNKING COMMON MYTHS

Misconceptions about what constitutes reasonable compensation often circulate within small business circles, including: 

  • Myth: No compensation. As hard as it is to believe, some tax professionals thought paying no compensation to shareholder-employees was acceptable to reduce tax liabilities. However, the IRS mandates fair wages to avoid tax evasion.
  • Myth: A minimum of $10,000 is a safe. The IRS sets no fixed minimum. Every case is evaluated based on specific circumstances, not a predetermined threshold.
  • Myth: Matching the Social Security base is adequate. While reaching the Social Security wage base might lessen IRS scrutiny, it doesn’t absolve a company from paying fair compensation. However, the IRS has significantly less recourse once you reach the Social Security wage base, $168,600 for 2024. Only the Medicare portion of the payroll tax applies above this wage level.
  • Myth: Relying on the 60/40 or 50/50 rule for guidance. This rule of thumb divides business income into two parts, with 60 (or 50) percent designated as salary and the other part paid as shareholder distributions. It’s currently espoused by many inside and out of the tax profession. Even ADP, the largest payroll processor, mentions this as a “rule” many tax professionals use. Still, with the disclaimer: “Although many accountants use the 60/40 rule of thumb, it’s not officially approved by the IRS.” While some tax professionals use 50 percent or 60 percent of profits before shareholder-employee compensation as a starting point, there is no guarantee that the allocated percentage will be reasonable.

UNDERSTANDING FAIR COMPENSATION

Determining reasonable compensation involves considering various factors. It's a nuanced assessment, factoring in industry norms, work scope, financial conditions, and specific IRS guidelines.

Reasonable compensation to shareholder-employees often comes down to common sense. What would a non-shareholder-employee be paid in a similar situation? While profits are not the sole factor, the financial condition of S corporation is. It’s reasonable to have lower compensation when profits or losses are low for an S corporation.

To determine reasonable compensation, S corporation owners can research using the Bureau of Labor Statistics or engage with resources like Robert Half's calculator or firms specializing in this area, such as AAG Accounting Services. To navigate the litany of factors that determine reasonable compensation, it helps to have the assistance of a Certified Tax Coach.

STRATEGIES TO NAVIGATE RISK

What if your S corporation can't afford to pay its employees a fair wage? Can it opt to pay less or skip compensation for its shareholder-employees? Let's explore the implications and remedies in such scenarios.

One option for the shareholder-employee is to decline compensation temporarily, catching up on payments in subsequent years. It's crucial to understand that reasonable compensation should precede any distributions from the corporation. The IRS focuses on the amount received by the shareholder, emphasizing that distributions should not surpass this reasonable compensation.

If an S corporation lacks the resources to meet reasonable compensation requirements, the owner can decline all compensation. However, if the corporation pays less than reasonable compensation and proceeds to distribute profits, the IRS might reclassify these distributions as wages until the fair compensation level is met. While this would have a minor effect on income taxes, payroll taxes would increase, and the penalties on payroll taxes are significant.

There's an important caveat: if reasonable compensation is reduced or skipped in a year, it must be compensated for before future distributions. Here are a few examples to illustrate these scenarios:

  • Example 1: XYZ Inc., an S corporation, mandates $100,000 as reasonable compensation. If the shareholder-employee takes a $100,000 salary before any distributions, it aligns with guidelines, causing no issues.
  • Example 2: During financial strain, the owner of XYZ Inc. opts for no compensation or distributions. However, suppose distributions are sought in the following year. In that case, the corporation must pay $200,000 in wages ($100,000 for the current year and the previous year's missed compensation) before any distributions can be made. If the distribution is before reasonable compensation, the IRS can recharacterize a proportional amount to cover reasonable compensation.
  • Example 3: In a different scenario, XYZ Inc. manages to pay only $50,000 in compensation. Before any distributions can be made, the unpaid $50,000 in reasonable compensation from that year must be reconciled.

In each of these examples, there are consequences. A shareholder-employee paid less than reasonable compensation could affect her Social Security benefits. Contributions to retirement plans could be limited, lowering the future value of these accounts in retirement. Certain tax credits on the S corporation owner’s personal income tax return could be negatively affected.

While delaying reasonable compensation might offer slight advantages in Social Security taxes when caught up, it isn't a substantial tax-saving strategy. Prioritizing fair compensation remains vital for S corporations, as skipping or reducing it almost always leads to adverse outcomes.

There is no free lunch. Reasonable compensation, even from prior years, must be paid before distributions.

SUMMARY

While S corporations are a powerful tool for small businesses, navigating the intricacies of reasonable compensation, tax compliance, and distribution protocols within S corporations demands expertise and careful consideration. By engaging a certified tax coach, businesses can proactively address the nuanced requirements of reasonable compensation. This proactive approach not only fosters compliance but also supports the S corporation's long-term financial health and stability.

To proactively address the nuanced requirements of reasonable compensation and ensure you’re getting the most out of your S corporation, start by reaching out today.