FAQs

Frequently Asked Questions (FAQs) for S Corporation Reasonable Compensation

1. What is "reasonable compensation" for an S Corp owner-employee? Reasonable compensation refers to the amount of salary that an S Corporation must pay to its owner-employee that is comparable to what other businesses would pay for similar work in the same industry and geographic area. The IRS requires that S Corporation owners who perform services for the business pay themselves a reasonable salary to avoid avoiding employment taxes.

2. Why does the IRS care about reasonable compensation? The IRS cares about reasonable compensation to ensure that business owners don't avoid paying employment taxes by taking large distributions instead of salaries. The IRS wants to make sure that S Corp owners pay themselves a reasonable salary subject to Social Security, Medicare, and unemployment taxes.

3. How do I determine what a reasonable salary is? Reasonable salary is determined by factors such as:

• The duties and responsibilities of the owner-employee

• The amount of time spent working in the business

• The compensation paid by other businesses for similar work in your industry and geographic area

• The experience and qualifications of the owner-employee

• The company's financial status

4. Can I pay myself a salary of $1 to minimize taxes? No. While there’s no set minimum salary, the IRS expects a reasonable salary based on the work performed. A $1 salary is highly unlikely to be deemed reasonable, and this could result in IRS penalties and reclassification of distributions as wages subject to taxes.

5. How do I avoid the risk of IRS audits regarding reasonable compensation? To avoid scrutiny from the IRS, ensure that the salary you pay yourself aligns with industry standards, the scope of your role, and the hours you work. Keep records and documentation to justify the salary you determine. This includes salary surveys, employment contracts, and other relevant data to demonstrate that your salary is reasonable.

6. What is the difference between salary and distributions in an S Corp? Salary is the wages you pay yourself as an employee, which are subject to employment taxes (Social Security, Medicare, etc.). Distributions are the profits the S Corporation pays to shareholders, which are generally not subject to employment taxes. However, the IRS requires that you pay yourself a reasonable salary before taking distributions.

7. What happens if I don’t pay myself a reasonable salary? If you fail to pay yourself a reasonable salary, the IRS may reclassify distributions as wages and impose back taxes, penalties, and interest. This can result in significant financial consequences for the business owner.

8. Can I take a distribution instead of paying myself a salary? You can take distributions, but only after paying yourself a reasonable salary that is subject to employment taxes. Taking large distributions without a reasonable salary could attract IRS scrutiny.

9. What happens if my S Corporation has no profits but I still want to pay myself a salary? An S Corporation is not required to pay a salary if there are no profits, but the salary must be reasonable in relation to the work performed. If the business is struggling, you might reduce your salary to match the financial situation, but it still needs to be reasonable based on your role in the company.

10. Are there any specific rules or guidelines from the IRS on reasonable compensation? The IRS does not provide a specific formula for reasonable compensation but looks at several factors. The IRS expects businesses to determine reasonable compensation based on the work performed, the size of the business, and industry standards. It’s important to document how the salary was determined to ensure compliance.

11. How can I document my reasonable compensation? To demonstrate that your compensation is reasonable, you should keep:

• Salary surveys and industry data showing typical pay for similar roles

• A written description of your role and responsibilities

• Records of hours worked and any compensation paid to employees with similar duties

• Any relevant contracts or agreements

12. Can I change my salary during the year? Yes, you can adjust your salary during the year as long as the salary remains reasonable for the services you perform. However, keep in mind that changes should be based on the work performed and the business’s financial health.

13. Can I pay myself a dividend instead of a salary? While an S Corp owner can take distributions, these are not a substitute for a reasonable salary. The IRS requires that a reasonable salary be paid before distributions can be taken, to ensure proper taxation of wages.

14. Are there any penalties for failing to comply with reasonable compensation rules? Yes. Failure to pay yourself a reasonable salary could result in the IRS reclassifying your distributions as wages, triggering payroll taxes (including Social Security and Medicare taxes) and penalties for underpayment, along with interest.

15. Do I have to pay myself a salary if I’m the only shareholder of the S Corporation? Yes, even if you are the sole shareholder, you must pay yourself a reasonable salary for the work you perform. The same rules for reasonable compensation apply regardless of the number of shareholders.

16. How can I avoid excessive compensation? To avoid excessive compensation, compare your salary to industry standards and keep your compensation consistent with your role, responsibilities, and the business’s financial health. Additionally, ensure that your salary is in line with what your company can afford.

17. What is the consequence of paying myself too high of a salary? Paying yourself an excessively high salary may trigger scrutiny from the IRS, leading to potential audits. If the IRS determines that the salary is excessive, they may reclassify the extra pay as a dividend or distribution, and it could be subject to different tax treatment.