S corporation owners: what “reasonable compensation” means

An S corporation’s profit passes through to its owners’ personal returns. Owners who also work in the business can be paid in two ways: wages, which carry payroll taxes, and distributions of profit, which do not. That difference is why the IRS pays close attention to how the two are balanced.

The rule

An owner who works in the business as an officer, performing more than minor services, is generally treated as an employee of the S corporation, and is expected to receive reasonable compensation for those services — as wages, through payroll — before taking distributions. When an owner-employee takes little or no salary and large distributions, the IRS can treat part of the distributions as wages, with the payroll taxes, penalties and interest that follow.

What “reasonable” is based on

There is no fixed percentage or ratio in the law. Reasonable compensation is what the business would have to pay someone else to do the work the owner does. The IRS has pointed to factors such as:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• What comparable businesses pay for similar services
• What the business pays non-owner employees
• Dividend history, and the timing and manner of bonuses
• Any compensation agreements, or formula used to set pay

A physician who sees patients full-time, a lawyer who runs a practice and an owner who spends a few hours a month overseeing the business are in very different positions, and their salaries should reflect that.

Documenting the number

The strongest position is a salary set deliberately and written down: the owner’s role and hours, the market data or reasoning used, and the date it was decided. Revisit it when the role or the business changes. A number chosen at year-end to make the payroll tax look smaller is the weakest position there is.

Why it belongs in planning

Salary affects more than payroll tax. It interacts with retirement contributions, with other deductions tied to wages and business income, and with the owner’s personal return. Those effects are easier to weigh during the year, in tax planning, than after it — and the business and owner returns are best prepared together.