Reasonable Compensation For S-Corp Owners & Why It’s Required

Image credit: Freepik

If you are a business owner who has recently made the S Corp election, you’ve probably heard a lot about tax savings. The ability to save on self-employment taxes is one of the biggest reasons business owners choose the S corporation structure. However, there is a catch: the IRS requires that corporation shareholder employees receive reasonable compensation for the work they do.

At Florida Virtual Bookkeeper ®, we focus on getting your books tax-ready using QuickBooks Online and Xero. While we don’t provide specific tax advice (that’s for your CPA or EA), we know how critical it is for small business owners to understand the IRS guidelines surrounding reasonable compensation for S Corp entities. Let’s break down what this means, why it’s required, and how to stay in the good graces of the tax agency.

What is an S-Corp and Who are “Shareholder Employees”?

First, let’s get our definitions straight. An S Corp is not a type of business like an LLC; it is a corp election made with the IRS. It allows a small business to be treated as a “pass-through” entity. 

This means the business income is not taxed at the corporate level. Instead, it “passes through” to the corporation owners, who report it on their individual income tax returns. This structure helps avoid the double taxation that traditional C corporations face.

If you are a sole shareholder or one of several S Corp owners, and you provide significant services to the company (like managing clients, performing the work, or overseeing operations), the IRS considers you a shareholder employee. 

You aren’t just an owner taking profits; you are an employee of your own company. Because of this, you must be paid employee wages via a W-2, just like any other staff member.

Why the IRS Cares: The Payroll Tax Loophole

The reason reasonable compensation is such a hot topic for IRS audits is simple: money.

In a disregarded entity, all profits are usually subject to employment taxes—specifically Social Security and Medicare taxes (together known as FICA). These taxes total about 15.3%. 

However, in an S corporation, only the wages paid to the shareholder employee are subject to these employment taxes and Federal Unemployment Tax (FUTA). Any remaining profit, known as S Corp distributions or corp distributions, is not subject to these taxes.

• Example: If your business earns $100,000 in taxable income and you pay yourself a reasonable salary of $60,000, you only pay payroll taxes on that $60,000. The remaining $40,000 in shareholder distributions is free from Social Security and Medicare taxes (but still subject to income tax), leading to a much lower tax bill.

If the tax law didn’t require a reasonable salary, every S corporation owner would pay themselves $0 in wages and take everything as a distribution to avoid taxes entirely. To prevent this, the IRS imposes that you must be paid reasonable compensation before taking any distributions.

How to Determine Reasonable Compensation

Image credit: Freepik

There is no magic formula to determine compensation that fits every business. Instead, the IRS looks at “facts and circumstances.” When you determine compensation, you are essentially asking: “What would I have to pay someone else to do this exact job?”

1. Market Research and Comparable Data

The IRS expects your salary to be comparable to what similar businesses would pay. You should look at what similar companies pay in your geographic area and industry. You can find this data through labor statistics (like the Bureau of Labor Statistics) or industry-specific salary comparable reports.

2. The Nature of Your Work

Your individual circumstances matter. The IRS considers the time and effort devoted to the business. If you are a corporation shareholder who works 60 hours a week and generates 90% of the generating income for the firm, your reasonable salary should reflect that. Conversely, if you only provide oversight once a month, your salary would be much lower.

3. The “Hypothetical Investor” Test

Courts often use the hypothetical investor test. This asks whether an outside investor would be happy with the company’s profit after your salary is paid. If your salary is so high it leaves no profit, or so low it makes the profit look artificially inflated, it might not be considered “reasonable.”

4. Other Factors

The tax agency also looks at:

• Business dividend history payments: Does the company have a past of dividend history?
• Manner of paying bonuses: Are you paying bonuses in a way that looks like disguised distributions?
• Compensation agreements: Do you have formal compensation agreements in place?
• Non shareholder employees: What are you paying your non shareholder employees? If your assistant makes more than you, the sole shareholder, that’s a red flag.

Red Flags and The Risks of Getting it Wrong

If you fail to pay a corp reasonable salary, you are inviting tax penalties and a potential audit. During a review, the IRS can reclassify your S corp distributions as wages. If that happens, you’ll be hit with:

1. Back Taxes: You will owe all the employment taxes you skipped.
2. Interest: You’ll pay interest on those unpaid taxes from the tax year they were due.
3. Tax Penalties: These can be substantial, sometimes as high as 100% of the unpaid tax in cases of “willful” neglect.
4. Loss of Status: In extreme cases, you could lose your S corp status entirely, reverting your corporation status back to a C-Corp or a multi-member LLC.

Be careful with shareholder loans as well. If you take “loans” from the business instead of a salary and never pay them back, the IRS will likely treat those as compensation payments subject to tax.

The Role of Bookkeeping in Compliance

Maintaining accurate financial records is your best defense. You cannot perform a reasonable compensation analysis at the end of the year if your financial records are a mess.

At Florida Virtual Bookkeeper™®, we help S corp owners stay organized throughout the year. While we aren’t the ones to tell you the exact dollar amount of your reasonable compensation—your tax preparer should do that—we ensure that your payroll taxes, wages paid, and S corp distributions are tracked accurately in your accounting software.

By having your books “tax ready,” you make it easy for your tax professional to:

• Verify your business income.
• Look at business dividend history payments.
• Ensure you aren’t accidentally misclassifying independent contractors or non-employee compensation.
• Use your financial records to defend your salary if you are ever questioned.

Conclusion: Play by the Rules to Keep the Savings

The S corporation is a powerful tool for tax savings, but it isn’t a “get out of taxes free” card. By paying yourself a reasonable salary that reflects the effort devoted to your business, you protect your limited liability and your S corp status.

Don’t wait until April to think about this. Reasonable compensation must be handled through payroll throughout the year. If your books aren’t currently tracking your salaries paid versus your shareholder distributions correctly, you could be at risk. We invite you to book a discovery session and find out how the experts at Florida Virtual Bookkeeper ® can help your business stay compliant and thrive.