Are you an officer of a corporation and need to know what the IRS considers reasonable compensation?
It is important to note that reasonable compensation doesn’t apply to partnerships or sole proprietorships because these individuals are not considered employees since they do not receive a W-2 statement. Instead, their earnings are subject to income and self-employment taxes regardless of how they’re received. On the other hand, reasonable compensation comes into play with C corporations and S corporations specifically when owners pay themselves. In most situations, taxpayers are better off when it comes to their taxes to pay employees a higher salary than themselves.
C corporations are able to deduct no more than a “reasonable allowance for salaries and other compensation personal services”. This is considered a necessary expense for businesses and the amount that is considered “reasonable” services as the top amount that can be deducted. If the IRS were to challenge a taxpayer and find that the compensation is unreasonable the IRS would then argue that the compensation is unreasonable and is not tax deductible.
For S corporations, on the other hand, there is a minimum amount that is necessary to prevent a recast of earnings of distributions into wages. The IRS would challenge an S corporation if they felt compensation was unreasonable and would argue that the amount paid was insufficient to avoid employment taxes.
C corporations offer two levels of taxation, one at the entity level and a second at the shareholder level after profits have been distributed. Since S corporations offer-pass through taxation they are only taxed at the shareholder level.
Although S corps are more favorable due to tax purposes, they still have more restrictive qualification requirements such as they must be a domestic corporation, cannot have more than 100 shareholders (who must be individuals or certain trusts or estates, and it can only have one class of stock.
It can be difficult to determine what is considered “reasonable compensation” for business owners, however, courts have provided a list of factors to consider when determining compensation:
(i) training and experience,
(ii) duties and responsibilities,
(iii) time and effort devoted to the business,
iv) dividend history,
(v) payments to non-shareholder employees,
(vi) timing and manner of paying bonuses to key people,
(vii) what comparable businesses pay for similar services,
(viii) compensation agreements, and
(ix) the use of a formula to determine compensation.
With this in mind, determining what is considered reasonable compensation is more of an art than a science. Most practitioners recommend a 60-40 approach as a rule of thumb.
For example, 60% of the amounts distributed to shareholders should be categorized as wages while the other 40% should be distributed as profit.
Determining a reasonable salary can be a confusing, daunting task. If you are unsure how much you should pay yourself through wages, seek out advice from a qualified tax professional.