What is reasonable compensation for an S-Corp owner?

Reasonable compensation is the salary an S-Corporation must pay owner-employees before they can take tax-advantaged distributions. Getting this number right is critical: too low and you face IRS reclassification; too high and you are paying unnecessary payroll taxes.

Why reasonable compensation matters

The S-Corp tax strategy works by splitting income between: 1. A salary (subject to FICA payroll taxes: 15.3% on salary up to the Social Security wage base) 2. Distributions (not subject to FICA)

If owner-employees pay themselves $0 salary and take everything as distributions, they avoid FICA entirely. The IRS specifically targets this strategy and has been winning cases against underpaying S-Corp owners since the 1970s.

The IRS standard: what would you pay someone else?

The IRS does not publish a specific formula for reasonable compensation. The standard is: what would you have to pay an independent third party to perform the same services? Factors considered by courts and the IRS include:

• Training and experience of the shareholder-employee
• Duties and responsibilities performed
• Time and effort devoted to the business
• Dividend history (consistent distributions with minimal salary is a red flag)
• Payments to non-shareholder employees in comparable roles
• Comparable salaries for similar positions in the same industry and geographic area
• Economic conditions (startup vs. established business)

How to determine your reasonable compensation

There are several practical approaches:

1. Bureau of Labor Statistics (BLS) wages: Look up the median or mean salary for your occupation in your geographic area using BLS Occupational Employment and Wage Statistics. This provides third-party market data the IRS accepts.

2. Professional salary surveys: Industry associations and sites like Salary.com, Glassdoor, or PayScale provide comparable compensation data.

3. The 60/40 rule (a heuristic, not a law): Some practitioners use a rough 60% salary / 40% distribution split as a starting point. This is a rule of thumb, not an IRS standard, and should not be used mechanically without considering your specific role and industry.

4. Comparable roles: Look at job postings for comparable positions in your area. Document these in your file.

Document your determination

The most important step is documentation. Prepare a memo each year that explains: - What services you provided to the S-Corp - The comparable positions you researched and their pay ranges - How you arrived at your salary figure - The annual salary approved by the board of directors (even if you are the sole director)

This memo, kept in your corporate records, is your defence if the IRS questions your compensation.

When no salary is acceptable

The only time an S-Corp owner can legitimately receive $0 salary is if the corporation has no profit and literally cannot afford to pay the owner. A corporation distributing profits to the owner while paying them nothing is a clear audit target.

State considerations

Some states, including California and New York, have their own rules on reasonable compensation and may impose additional employment taxes. Always verify state-level implications.

Consequences of unreasonably low compensation

If the IRS reclassifies distributions as wages: - Back FICA taxes are assessed on the reclassified amounts - Interest is charged from the original payment date - Penalties may be assessed on the employer and employee FICA portions - Accuracy-related penalties of 20% may apply to the underpayment - The S-Corp may also be assessed the employer share of FICA (7.65%)

Court cases have seen the IRS reclassify hundreds of thousands of dollars in distributions as wages when owners paid themselves nominal salaries. The combined back-tax, interest, and penalty bill can be substantial.