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What is Reasonable Compensation?

One of the recent hot topics with respect to the IRS audits has to do with auditing S corporations[1] (and those taxed like an S, such an LLC) for not paying their employee/owners “reasonable compensation. According to the IRS “S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee” (IRS.gov, “S Corporation Compensation and Medical Insurance Issues,” 8/31/2013).

The reason for the increasing prevalence of S corporation reasonable compensation audits is because a number of taxpayers were forming S corporations to avoid the self-employment tax that would be otherwise charged on their net income. Rather than paying themselves a salary (subject to Social Security and Medicare tax), the owner would just take the entire net profit as a distribution on their personal income tax return (as a reminder, S corporations are flow through entities and pay no federal corporate income tax). As a result of this distribution, they avoid contributing to Social Security and Medicare by not having to pay self-employment tax on the distribution and not subjecting themselves to ordinary Social Security and Medicare tax on any ways paid. As a result, an S corporation that makes a distribution or other type of payment to a corporate officer must treat the distribution “as wages to the extent the amounts are reasonable compensation for the service rendered to the corporation” (“S Corporation Compensation and Medical Insurance Issues”). These provisions are outlined in the instructions to Form 1120S, U.S. Income Tax Return for an S corporation.

The IRS bases their authority to audit S corporations for reasonable compensation on multiple federal court cases. As the IRS notes, “Several court cases[2] support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense and subject to employment taxes” (“S Corporation Compensation and Medical Insurance Issues”). For more information about additional cases, visit the S corporation Compensation and Medical Insurance Issues section of the IRS website.

Determining reasonable compensation must first be established by evaluating what the shareholder-employee did for the S corporation. To best understand the role of the shareholder-employee, the IRS examines the source of the S corporation’s gross receipts. There are three major sources: 1) services of shareholder, 2) services of non-shareholder employees, and 3) capital and equipment. “If the gross receipts and profits come from items 2 and 3, then that should not be associated with the shareholder-employees personal services and not be allocated as compensation” (“S Corporation Compensation and Medical Insurance Issues”). However, if the total of gross receipts and profits derives from shareholder personal services, then the IRS will reasonably assume that most of the profit distribution is allocated as compensation” (“S Corporation Compensation and Medical Insurance Issues”).

Owner-employees are also compensated for administrative work that is generally performed for other income producing employees or assets (“S Corporation Compensation and Medical Insurance Issues”). Additional factors that determine reasonable compensation include: training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, payments to non-shareholder employees, and compensation agreements. There are additional factors that determine reasonable compensation such as the use of a formula as a tool for calculating compensation and payments to non-shareholder employees.

Reasonable compensation issues are something I get asked about a lot as an attorney and my answers vary from client to client. The reason for this is that what is considered “reasonable” is a very fact based determination based on the circumstances of the client business. The percentage of distribution that must be taken as “wages” vs. what can be taken as a “distribution” is highly subjective (shaped by current case law). If you are concerned about the possibility of a reasonable compensation audit, please contact me through the information on this website so that I can examine your current policies and practices.

[1] An S Corporation is defined in terms of U.S. federal income tax designation. It is a corporation that elects to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. An S Corporation does not pay federal income taxes. Instead, the corporation’s losses and/or income are divided among and passed through to its shareholders. The shareholders report the income or loss on their individual tax returns.

[2] References to court cases include the following: authority to reclassify (Joly vs. Commissioner, 211 F.3d 1269 [6th Cir., 2000]); reinforced employment status of shareholders: Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 (2002).