Understanding Reasonable Compensation in an S-Corp

One of the reasons to choose an S-Corp instead of an LLC as the vehicle for a small business can be tax savings. An S-Corp does not pay any taxes at the corporate level, but instead all income is passed through to the shareholders, who are responsible for a number of taxes on both salary and dividend (return on investment).

The IRS and Department of Labor are cooperating to investigate companies that misclassify employees as independent contractors to try to avoid paying taxes. The heightened scrutiny onpayroll withholdings could make S-Corporations more likely to be audited.

In addition, many entrepreneurs have a misunderstanding about how to pay themselves. They often mistakenly believe they do not have to pay themselves a salary at all, but can take only distributionsof profits. Distributions are not subject to self-employment tax, only income tax.

However, the IRS is looking for the owners of an S-Corp who work in the business to take a “reasonable” salary (which is subject to both income tax, and, up to a certain amount, withholdings for social security, Medicare, and unemployment taxes). After the reasonable salary is paid, the owners can distribute the remainder of the profits, which are subject only to income tax. These distributions are not treated as self-employment income, which is a tax advantage over LLCs, partnerships and sole proprietorships.

Determining what is a reasonable salary is tricky. Paying no salary compensation will almost certainly trigger an audit, but so will paying too little salary compensation. The IRS could re-characterize the resulting distributions as wages, and attach penalties for not withholding and paying proper payroll

taxes.

Some shareholders hire themselves as independent contractors to save on the payroll taxes. This can trigger not only an audit, but significant penalties for misclassification of workers.

As a general rule, zero salary is unreasonable, as is a salary below the minimum wage.

The IRS will consider the following factors to determine whether a salary is reasonable (or too low):

1. Employee qualifications;

2. The nature, extent, and scope of the employee’s work;

3. The size and complexity of the business;

4. Prevailing general economic conditions;

5. The employee’s compensation as a percentage of gross and net income;

6. The employee-shareholder’s compensation compared with distributions to shareholders;

7. The employee-shareholder’s compensation compared with that to non-shareholder employees

or paid in prior years;

8. Prevailing rates of compensation for comparable positions in comparable concerns; and

9. Comparison of compensation paid to a particular shareholder-employee in previous years,