Reasonable Compensation

What is Reasonable Compensation?

Reasonable Compensation in a Nutshell

1. All S-Corp shareholder-employees must pay themselves a reasonable salary (i.e. Reasonable Compensation) via W-2 BEFORE any distributions are taken. It's the law.

  2.  You should complete a Reasonable Compensation analysis each year using one of the three IRS-approved approaches.

  3.  Keep a record of all supporting documentation for your figure each year.

 There are many tax benefits to filing as an S-Corp, but you should be aware of the additional responsibilities you have including:

  •    S-Corp shareholder-employees must pay themselves reasonable wages (i.e. Reasonable Compensation) via W-2 before taking any distributions from the business

  •    You will need to file an additional tax return for the business as an S-Corp

  •    Some states impose additional fees to S-Corps

  •    There may be filing fees associated with becoming an S-Corp

What is Reasonable Compensation?

If you aren't sure if an S-Corp is right for you, ask your accounting professional to run an Entity Planning Analysis to see what makes the most sense for your business.

The biggest struggle for most S-Corp owners is defining Reasonable Compensation.

The IRS defines Reasonable Compensation as: the value that would ordinarily be paid for like services by like enterprises under like circumstances. ~ IRS Code: Section 162-7(b)(3)

 To put it in simpler terms, you can ask yourself, "How much compensation would be paid for this same position, held by a non-owner in an arms-length employment relationship, at a similar company?"

 A few key things to keep in mind:

  •    Reasonable Compensation is based on the value of the service provided, not profits or distributions.

  •    Wages (i.e. Reasonable Compensation) should be paid before distributions and must be paid via W-2.

•    A shareholder-employee can take wages without taking a distribution, but not vice versa.

 •    A shareholder-employee who does not want to take Reasonable Compensation can refuse all compensation and play "catch-up" in a later year.