The agreement must align with market data and be supported by credible documentation. Having a compensation agreement alone does not shield you from scrutiny. Instead, it is based on the value of the services you provide. Reasonable compensation is not automatically tied to an S-Corp’s profitability. While this can be true for a given year, the IRS looks at cumulative distributions and salaries over time.

Utilizing Compensation Formulas

Mr. Goldsmith argues that because during those years G&A made no money, it could not have afforded to pay him wages, and any money he took out of G&A was to reimburse him for G&A expenses he himself had paid earlier. After he was released from prison, he faced a civil audit where – in part – the IRS attempted to reclassify loan repayments and returns of capital as wages. , the taxpayer was an attorney who ran into horrific financial troubles (his firm worked on contingency cases and he was unable to manage the cashflow challenges, leading him to predatory loans and financial ruin). The IRS attempted to categorize all loan repayments and dividends as wages. LEXIS (D. Colo. 1994), the taxpayers were able to get the IRS’s proposed assessment of $39,221 down to $647.

Common Myths About Reasonable Compensation

Most distributions are in money, but they may also be in stock or other property. The procedures for compensating yourself for your efforts in carrying on a trade or business will depend on the type of business structure you elect. Furthermore, we do not endorse any third-party companies, products, or services described here and cannot take responsibility of how the information is used.

The IRS struggles to argue you’re worth less now as a business owner than you were as an employee performing similar work. If you previously worked as a W-2 employee in a comparable role before forming your S corp, matching or exceeding your prior salary provides strong justification. Recent court decisions suggest shareholder-employees should receive salaries equal to at least 60-70% of comparable market rates. Certain approaches reduce IRS scrutiny while maximizing tax reasonable salaries and s corps benefits when filing s corp taxes. This myth assumes the Social Security maximum automatically constitutes reasonable compensation for all roles.

To help you understand it all, let’s look at why S corporations are different from corporations, and then how to avoid tax issues for S corp owners. The information you need to prove you’ve paid a reasonable compensation to shareholders is unfortunately unclear. When thinking about reasonable compensation, it’s best to approach the salary the same you would with a new employee. Because salaries are subject to employment taxes and distributions aren’t, shareholders want to minimize their salaries. Additionally, shareholders in an S corp will not pay self-employment tax.

• Whether you’re newly electing S corp status or optimizing an existing structure, our expertise ensures your salary maximizes tax savings while withstanding IRS scrutiny.
• If you earned $95,000 as an employed marketing manager and now run a marketing consulting S corp, paying yourself at least $95,000 creates defensible s corp tax filing compensation.
• Some believe paying yourself the Social Security wage base ($176,100 for 2025) creates a safe harbor.
• In this article, I’ll cover all that to give you a good foundation for exploring whether the S Corporation election might benefit your company.

Is Your Compensation Reasonable? A Guide for C Corp and S Corp Business Owners

To combat this, the IRS has their rule on reasonable compensation. This increases the S corporation’s net profits and therefore their distributions. Becoming an S corporation can save you money on your tax bill. Hear straight from our customers why thousands of small business owners trust Bench with their finances

How does the IRS determine if my S-Corp salary is reasonable?

Conversely, if comparable positions pay $250,000-$300,000, paying $176,100 remains unreasonably low. Some believe paying yourself the Social Security wage base ($176,100 for 2025) creates a safe harbor. Establish and document compensation decisions contemporaneously. Retroactive compensation agreements created after IRS inquiry carry little weight.

Understanding S Corporations

These procedures help ensure compliance with tax regulations and provide an accurate understanding of the company’s financials. This evaluation provides valuable insight into industry standards, enabling a justifiable salary determination based on market rates. Bonuses should be based on performance and paid consistently across all employees, including shareholder-employees. The timing and manner of paying bonuses to key people are crucial elements in the S Corp’s payroll consideration. Using software or working with a payroll provider can help simplify this process and ensure accuracy.

• The state minimum wage ranges from $16-20 per hour depending on location and company size, establishing a floor for any salary determination.
• These benefits can be part of your total compensation package but should be offered consistently to eligible employees.
• The key phrase that governs this entire process is “reasonable compensation.” Getting this wrong can lead to costly tax adjustments and penalties.
• In some cases, the owner labor is minimal.
• For example, if you are the CEO of a large corporation, your salary will likely be higher than that of a small business owner with less experience.

IRS Red Flags That Trigger Audits

S Corp owners must pay “reasonable compensation” to each shareholder/employee in exchange for any services provided by the shareholder-employee. The IRS requires S corporation shareholders who provide substantial services to the business to receive fair market wages before taking any distributions. The beauty of the tax law for owners of S Corporations is that they only must pay payroll taxes on wages—not the shareholder distributions. However, the business owners who work in the business are considered employees and only pay Social Security and Medicare taxes (FICA) on the wages and salaries they receive from the company.

Penalties for unreasonable compensation

Regular, consistent distributions to all shareholders based on ownership percentages demonstrate legitimate profit distributions rather than compensation avoidance. Generally, these and other formulas provide simple guides for what to pay shareholders, but they are problematic in that most don’t consider the factors the IRS recommends using to determine reasonable compensation. Because wages are a deductible expense for C Corporations, some owners have taken excessive profits as their salary (which is tax deductible for the business) rather than dividends (which are not tax deductible). Choosing to be an S Corporation can also benefit Corporations because it allows the owners to save on payroll taxes, which include self-employment taxes. Understanding some things about Limited Liability Company (LLC) and C Corporation taxes first can help you grasp how the S Corporation election works and why business owners might choose that option.

Each situation requires individual analysis based on market rates, actual duties, and specific circumstances. In severe cases, this triggers broader audits of your business returns. Research your state’s specific changes as they affect total compensation costs. “Due to 40% revenue decline from supply chain disruptions, officer compensation is temporarily reduced to preserve operations.” The IRS shows flexibility for legitimate business struggles.

What Does the IRS Consider “Reasonable”?

Failing to pay yourself a “reasonable” salary could trigger tax reclassification, penalties, and unwanted audits. According to IRS guidelines, a reasonable salary is one that is comparable to what someone in a similar position would earn in a similar company. As an owner of an S-Corp, it’s important to determine a reasonable salary for yourself to avoid potential IRS audit risk. Self-employment taxes are Social Security and Medicare taxes that self-employed individuals must pay on their income.

Your salary should equal or exceed what you pay your highest non-shareholder employee. You’ve maximized Social Security contributions, making it difficult for the IRS to argue you’re avoiding payroll taxes. If comparable positions pay $120,000, your reasonable salary should fall in the $72,000-$84,000 minimum range (60-70%). This guideline provides a starting point for s corp reasonable compensation determinations. Determining your reasonable salary for s corp purposes requires systematic analysis using multiple data sources and methodologies.

A commonly touted strategy to set your S Corp salary is to split revenue between your salary and distributions — 60% as salary, 40% as distributions. If there’s money left over after that, you can pay yourself distributions. Or, if you were employed in a similar role before, what was your salary as an employee? You could pay tax penalties of up to 100%, plus negligence penalties.

But if the IRS thinks you’re underpaying yourself in wages, it can reclassify those distributions as taxable income—adding back taxes, interest, and penalties. Setting your own salary as a business owner may seem straightforward—but if you’re operating as a C corporation or S corporation, the IRS is paying attention. The IRS expects S-Corp owners to pay themselves a reasonable salary based on their job duties and industry standards. First, it’s important to understand that while the IRS does provide some guidance for determining a reasonable salary for S-Corp owners, it is not exact. Conversely, if you only take salary and no distributions, you’re likely to incur an unnecessarily high amount of payroll taxes.