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[Prefer to listen? You can find a podcast version of this article here: E249: Reasonable Compensation for S-Corps – Busting Common Myths] 

Reasonable compensation is one of the most misunderstood and debated topics for S-Corporation (S-Corp) owners. Despite its importance, misconceptions continue to circulate, often leading to IRS challenges or costly mistakes. Let’s break down what S-corp reasonable compensation is, why it matters, and bust some of the most common myths.

What Is Reasonable Compensation?

At its core, reasonable compensation is the salary that an S-Corp shareholder-employee must take for the services they provide to the business. This concept prevents S-Corp owners from avoiding payroll taxes by taking distributions instead of a salary. The IRS defines reasonable compensation as the value that would ordinarily be paid for like services by similar businesses under similar circumstances.

To put it simply, what would it cost to replace yourself in your business? Or, what would another company pay you for the same duties?

The Stakes Are High

The IRS has made reasonable compensation a priority. Audits focusing on this issue have increased significantly, as seen in the surge of court cases over the last decade. Failure to pay reasonable compensation can lead to payroll tax recharacterizations, penalties, and interest.

For instance, in the famous Watson case, the IRS recharacterized over $134,000 of distributions as wages, resulting in nearly $50,000 in additional taxes, penalties, and interest.

Common Myths About Reasonable Compensation

Myth 1: You Can Pay Yourself Any Amount You Choose

Some believe that as a business owner, they can set their salary at any level. This is false. The IRS uses a "replacement cost" or "fair market value" approach to assess reasonable compensation. For example, if you are a CPA managing a firm, the IRS expects your salary to reflect the market rate for someone with your expertise and responsibilities.

Myth 2: You Don’t Need a Salary if You Don’t Take Distributions

If an S-Corp owner takes no distributions and leaves all profits in the business, they may think they can skip a salary. While this can be true for a given year, the IRS looks at cumulative distributions and salaries over time. If you later take distributions without paying yourself a reasonable salary, the IRS may recharacterize those distributions retroactively.

Myth 3: Reasonable Compensation Equals Net Income

Reasonable compensation is not automatically tied to an S-Corp’s profitability. Instead, it is based on the value of the services you provide. For instance, a shareholder-employee who generates gross receipts through personal services must pay themselves accordingly, regardless of the company’s overall net profit.

Myth 4: Small S-Corps Can Skip Payroll

Even small, single-shareholder S-Corps must pay reasonable compensation if the shareholder performs services. This includes part-time roles, as seen in the Davis case, where a shareholder working only 12 hours per month had to pay herself $8 per hour in wages.

Myth 5: A Compensation Agreement Is Enough

Having a compensation agreement alone does not shield you from scrutiny. The agreement must align with market data and be supported by credible documentation. Courts have dismissed agreements that were not arms-length or realistic, as in the McAlry case.

How the IRS Evaluates Reasonable Compensation

The IRS uses three main approaches to determine reasonable compensation:

1. Cost Approach: Focuses on replacement cost by analyzing the shareholder’s tasks and assigning wages based on skill level and time spent (most common for small businesses).
2. Market Approach: Compares the shareholder’s compensation to others in similar roles at similar companies.
3. Income Approach: Allocates compensation based on a percentage of the company’s gross receipts attributable to the shareholder’s personal services.

Real-World Cases: Lessons Learned

Watson Case: A CPA paid himself $24,000 in salary while taking $203,000 in distributions. The IRS argued that $24,000 was unreasonably low given his graduate degree, 20 years of experience, and full-time dedication to his firm. They determined his replacement cost to be $91,044 annually. Using this figure, the IRS recharacterized $67,044 of distributions for each audited year (2002 and 2003) as wages, resulting in a total recharacterization of $134,088. This led to nearly $50,000 in back taxes, penalties, and interest, calculated by applying payroll tax rates, late payment penalties, and accrued interest over the years. The court upheld the IRS’s assessment, emphasizing the importance of credible documentation and market comparability in setting reasonable compensation.

• Reference: Eighth Circuit agrees that CPA was underpaid

McAlary Case: A real estate professional argued for a $24,000 salary but was found to have duties warranting $83,200. The court looked at his multiple roles, hours worked, and comparable wages to determine a reasonable figure.

• Reference: Sean McAlary Ltd., v. Comr., T.C. Sum. Op. 2013-62

Glass Blocks Case: An S-Corp owner with minimal income was still required to pay reasonable compensation due to improperly documented loans and distributions.

• Reference: Reasonable Compensation for S Corporation Shareholder-Employees

Best Practices for S-Corp Owners

• Document Everything: Maintain records of how you determine your salary. Use comparability data, industry wage surveys, and job descriptions to justify your compensation.
• Stress Test Your Salary: Evaluate your compensation against factors like your training, experience, duties, and hours worked.
• Use Professional Tools: There are services that can provide defensible compensation analyses, which auditors often accept without further challenge.
• Stay Proactive: Address compensation issues before year-end to avoid costly amendments or penalties.
• Consult Experts: Work with a tax professional to ensure your salary complies with IRS guidelines and aligns with your business’s financial goals.

The Bottom Line

Reasonable compensation is not a one-size-fits-all calculation, but it’s also not arbitrary. By understanding the IRS’s criteria and following best practices, S-Corp owners can reduce audit risks and ensure compliance. Remember, when in doubt, seek professional guidance to safeguard your business and financial well-being.