What It Means

Reasonable compensation is the fair market value of the services a shareholder-employee performs for their S-corporation. It represents the salary an owner should pay themselves for the work they do, reported as W-2 wages and subject to Social Security and Medicare (FICA) taxes. Shareholder distributions, on the other hand, are not subject to these employment taxes. The IRS expects owners who work in their business to first pay themselves a reasonable salary before taking distributions.

Why It Matters

If an owner only takes distributions without reporting wages, the IRS may reclassify those distributions as wages. This could mean back taxes, penalties, and interest. S-corporation tax returns (Form 1120-S) require officer salaries to be reported separately. If a return shows distributions but little or no officer wages, it increases the chance of IRS scrutiny.

Example

Imagine your business earns $100,000. If you take it all as a distribution and report no wages, the IRS could decide that $60,000 should have been wages. You would then owe payroll taxes, penalties, and interest on that amount. Paying yourself a reasonable salary upfront helps avoid this problem.

How "Reasonable" Is Determined

There's no single formula, but compensation is based on the facts and circumstances of your business. Key factors include:

1. Your training, experience, and role in the business
2. Duties, responsibilities, and time commitment
3. What employees in similar businesses are paid
4. The corporation's overall profitability
5. How multiple roles are divided among shareholders

A single owner often wears many hats. For example, consider an architect who owns an S-corporation. Beyond designing projects and meeting with clients, the owner may also handle budgeting, manage project teams, market the firm, prepare proposals, oversee compliance with building codes, and negotiate contracts. Each of these responsibilities adds value, and compensation must reflect the full range of work performed, not just the billable design hours.

Our Process

We help clients calculate a defensible and well-documented salary through:

1. Interview & Role Assessment - reviewing all services performed by the shareholder-employee
2. Market Benchmarking - comparing roles to wage data from reliable sources
3. Composite Salary Calculation - blending compensation based on time spent in each role
4. Comprehensive Report - providing a written analysis for your records
5. Ongoing Review - revisiting compensation as roles or the business change

Common Pitfalls to Avoid

1. Taking only distributions while providing substantial services
2. Setting wages without considering fair market value
3. Reporting large distributions but little or no officer wages
4. Not updating compensation when responsibilities expand

Audit Protection

Having a documented reasonable compensation report on file demonstrates good faith and reliance on credible data. This record can serve as strong protection if the IRS ever reviews your compensation practices.