October 30, 2014

S-Corporations: What is reasonable compensation?

Evaluating the blend of wages and distributions shareholders plan to receive from their S-Corporation requires a great deal of planning.  By consulting with Realize CPA LLP in the creation or continued planning stages of an S-corporation, shareholders gain several important benefits:

  • Shareholders can be sure they are maximizing the potential self-employment and payroll tax savings available to them.
  • Shareholders can be confident that the correct employment agreements and supporting documentation are put in place.
  • Shareholders can develop a consistent approach to calculating the split between wages and distributions each tax year.

Yearly reviews of the operations of the entity will ensure that all compensation decisions are consistent with the gross sales and profits of the business.

As taxpayers continue to utilize the tax advantages of S-corporations by minimizing their compensation, the IRS has ramped up its review of S-Corporation compensation.  In addition, the IRS is  levying penalties on  shareholders when their compensation does not reflect the operations of the business.  The penalty in this situation is 100% of the taxes owed on the income deemed to be incorrectly reported as distributions.

The IRS has issued guidance for taxpayers looking to better understand the factors it reviews in reasonable compensation cases and avoid the steep penalty listed above.

Below are nine factors that the IRS recommends carefully considering in determining reasonable compensation:

  1. Employee qualifications
  2. The nature, extent, and scope of the employee’s work
  3. The size and complexity of the business
  4. Prevailing general economic conditions
  5. The employee’s compensation as a percentage of gross and net income
  6. The employee-shareholder’s compensation compared with distributions to shareholders
  7. The employee-shareholder’s compensation compared with that to non-shareholder employees or paid in prior years
  8. Prevailing rates of compensation for comparable positions in comparable concerns
  9. Comparison of compensation paid to a particular shareholder-employee in previous years where the corporation has a limited number of officers.

By establishing a level of compensation congruent with these factors, you can put yourself in the best position to avoid litigation and create a defensible position for yourself and your business in the event that the IRS challenges the compensation.   Utilizing our services for this review is a very important part of this process.

At this time there is not a strict amount or percentage of S-corporation income that is recognized as “reasonable compensation”.  For that reason this will continue to be a topic that draws a great deal of attention from the IRS and requires thorough planning be in place.