The IRS defines reasonable compensation as the value that would ordinarily be paid for like services by like enterprises under like circumstances. In private companies, the shareholder(s) and/or their family members are often employees of the corporation. It is important for business owners to ensure that compensation paid to a shareholder-employee is reasonable.
Under a C Corporation structure, reasonable compensation has been codified to guard against excessive compensation paid to shareholder-employees. For S corporations, however, reasonable compensation has been driven more by revenue rulings and case law.
S Corporation shareholder-employees generally prefer dividend distributions of their profits over compensation because compensation payments are subject to payroll taxes and dividend distributions are not. The payroll tax impact could include a 6.2 percent Social Security tax, a 1.45 percent Medicare tax, a 0.9 percent additional Medicare tax, as well as local/city income taxes. On the other hand, income left within the S Corporation could be eligible for the 20 percent qualified business income deduction. For all these reasons, the net after-tax cash flow from a dividend distribution compared to compensation can be much greater.
The IRS acknowledges this and has a history of challenging situations where the compensation paid to shareholder-employees did not appear reasonable. In reviewing relevant case law, we have learned that business owners should be prepared to support the level of compensation based on the following factors:
- Nature of the business
- Employee title, qualifications, and responsibilities
- Comparison to compensation paid to non-shareholder employees
- Percentage of compensation payments to distributions
- Company conditions
When we assist clients in evaluating whether shareholder-employee compensation is reasonable, we utilize a salary survey. The salary survey takes into consideration the variables above, while also providing unbiased, “market rate” data to support salary and bonus levels. The survey, in addition to an evaluation of certain company-specific items, provides objective guidance that allows a business to support its shareholder-employees’ compensation levels.
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