by Matthew Cohen, CPA

If you are a sole proprietor or a non-passive member/partner of an LLC/partnership you pay self-employment tax on every dollar of earned income. Shareholders of S-corporations on the other hand pay no self-employment tax on their share of the company’s net income.

To ensure at least some employment tax gets paid, the IRS specifically requires that a shareholder of an S-corporation take reasonable compensation.  This is done in the form of a salary or wages.

Requirements

Below are a few key items to consider based on the IRS’s reasonable compensation requirements:

• Fair Market Value (FMV) The salary should reflect the fair market value of the services provided by the shareholder-employee. This involves considering the skills, experience, and responsibilities associated with the position
  

  

  Industry Standards The IRS considers industry standards when assessing the reasonableness of a shareholder’s salary. Comparisons with similar roles in the industry help establish a benchmark for appropriate compensation

• Job Responsibilities Shareholders often wear multiple hats within the organization, contributing to both executive and operational roles. The salary should align with the scope and significance of the shareholder’s responsibilities
• Geographical Location The cost of living and salary expectations vary by region. The IRS recognizes this and allows for adjustments based on the geographical location of the business
• Company Financial Health The overall financial health of the S Corporation is a crucial factor. The salary should be justifiable in the context of the company’s profitability and ability to cover payroll expenses
• Consistency The IRS looks for consistency in compensation practices. Fluctuations in salary that are not adequately justified may raise red flags. Shareholders should be compensated consistently based on their roles and responsibilities

As you can see, there are several factors that the IRS uses to determine ‘reasonable’ compensation.

Many of these do not necessarily positively correlate with each other. For this reason it is important to take a position based on the company’s specific circumstances and be prepared to defend it if necessary based on the facts.

Determining Reasonable Compensation

Setting a reasonable salary involves assessing various factors.  This can include the shareholder’s role in the company, industry standards, geographical location, and the company’s financial health. Shareholders often wear multiple hats within the organization.

They contribute to both executive and operational roles. Assuming the company has the means to pay the shareholder, reasonable salary should reflect the fair market value of the services rendered

If the company financial position does not allow the shareholder to be paid at fair market value, adjustments can be made to work with current cash flow.

The IRS emphasizes the importance of “reasonable compensation” to prevent S Corporations from inappropriately allocating income as distributions rather than salary to reduce payroll taxes. Paying an unreasonably low salary can attract unwanted attention and may lead to IRS audits and penalties.

Do Your Homework

To navigate this intricate terrain, S Corporations should do their due diligence. This can include conducting research on industry salary benchmarks, consulting with a compensation expert, and documenting the factors influencing their compensation decisions.

Maintaining a clear and well-documented record of the reasoning behind salary determinations can serve as a strong defense in case of an audit.

Summary

The delicate dance of determining a reasonable salary for S Corporation shareholders involves balancing fair compensation with tax efficiency. In some cases, it can be beneficial to increase a Shareholder’s compensation (i.e. to increase the allowable contribution to a SEP IRA or pension plan).

By carefully considering the various factors influencing this decision and staying informed about IRS guidelines, shareholders can navigate this complex landscape successfully. Striking the right balance not only ensures compliance with tax regulations but also ties into the long-term financial health of the S Corporation.

If you are a shareholder of an S-corporation  (or a member of an LLC taxed as and S-corp), be sure to consult your tax professional on not WHETHER you should take a salary but HOW MUCH you should take.