Reasonable Compensation

Reasonable Compensation for S-Corp Owners

For S Corporation (S-Corp) owners, understanding reasonable compensation is a cornerstone of effective tax planning and IRS compliance. The IRS closely scrutinizes S-Corp compensation practices to ensure shareholder-employees receive a fair salary for services rendered before taking distributions. Failing to comply with reasonable compensation requirements can lead to costly audits, penalties, and reclassification of distributions as wages.

This guide explores what reasonable compensation entails, why it matters for S-Corp owners, and best practices for determining and documenting it to optimize tax savings while staying compliant.

Write to Tax@S-CorpTax.com, or call (858) 779-4125.

What Is Reasonable Compensation for S-Corp Owners?

Reasonable compensation refers to the fair market value of wages paid to S-Corp shareholder-employees for the services they provide to the business. Unlike distributions, which are not subject to payroll taxes, salaries are subject to federal and state payroll taxes. The IRS requires S-Corp owners who perform services for their business to pay themselves a reasonable salary before taking profits as distributions.

The concept of reasonable compensation stems from the IRS's effort to prevent S-Corp owners from minimizing payroll taxes by classifying most of their income as distributions. For example, if an S-Corp owner sets an unrealistically low salary while taking large distributions, the IRS may reclassify a portion of those distributions as wages.

Why Reasonable Compensation Matters

S-Corps benefit from pass-through taxation, where business income is reported on shareholders' personal tax returns. This structure creates an incentive to minimize salaries and maximize distributions to reduce payroll tax liability. The IRS counters this by enforcing reasonable compensation rules.

Non-compliance can lead to:

  • IRS audits

  • Reclassification of distributions as wages

  • Back taxes, penalties, and interest

  • Loss of S-Corp tax benefits

IRS Guidelines for Reasonable Compensation

The IRS does not provide a fixed formula but offers guidance through Internal Revenue Code Section 162 and case law. Courts have outlined several factors to evaluate reasonableness:

  • Training and experience

  • Duties and responsibilities

  • Time and effort devoted

  • Compensation in similar businesses

  • Financial performance of the S-Corp

  • Payments to non-shareholder employees

  • Dividend history

For example, a CEO of a $1 million consulting firm in NYC requires a higher salary than someone in a smaller rural business.

IRS Tools and Resources

The IRS uses tools like the Reasonable Compensation Job Aid for IRS Valuation Professionals. Key data sources include:

  • Bureau of Labor Statistics (BLS)

  • PayScale

  • Salary.com

  • Regional cost-of-living data

  • Industry benchmarks

Best Practices for Determining Reasonable Compensation

1. Conduct a Market-Based Salary Analysis

  • Account for business size and geographic location

  • Document all findings for audit protection

2. Balance Salaries and Distributions

  • Ensure salary reflects fair market value

  • Monitor profit margins

  • Review compensation annually

3. Document Compensation Decisions

  • Maintain records in board minutes or resolutions

  • Use formal job descriptions

  • Retain salary survey and industry data

4. Understand the Role of Payroll Taxes

  • Salaries are subject to Social Security, Medicare, and income taxes

  • Distributions are only subject to income tax

  • Use payroll software to ensure compliance

5. Leverage Tax-Advantaged Benefits

  • Deduct health insurance premiums if included in W-2 wages

  • Contribute to retirement plans like SEP-IRA or Solo 401(k)

  • Use accountable plans for reimbursing expenses

6. Stay Compliant with State-Specific Requirements

  • Some states impose additional S-Corp taxes

  • Research and plan around state-specific rules

7. Work with a Tax Professional

  • Get help setting a defensible salary

  • Optimize the salary-distribution balance

  • Stay current with tax law changes

Common Mistakes to Avoid

  • Setting unreasonably low salaries

  • Failing to document decisions

  • Taking only salary without distributions

  • Overlooking tax-advantaged benefits

Scorpio Tax Management can support High Income Earners and Business Owners in all 50 states

Please write us at Tax@S-CorpTax.com, or call 858 779 4125!

California

We assist business owners in all the following California cities and their surrounding areas:

  • San Francisco, including Marin County (Sausalito, Mill Valley, Tiburon), Silicon Valley (Palo Alto, Menlo Park, Mountain View), and the entire East Bay (Oakland, Berkeley, Fremont).

  • Paso Robles, including Atascadero, San Luis Obispo, Morro Bay, and all other parts of the Central Coast.

  • Santa Barbara, including Buellton, Santa Ynez, Montecito, Ventura, Oxnard, and Carpinteria.

  • Los Angeles, including Malibu, Santa Monica, Beverly Hills, Hollywood, South Bay (Manhattan Beach, Redondo Beach), and Pasadena.

  • Orange County, including Anaheim, Huntington Beach, Newport Beach, Irvine, Laguna Beach, and Costa Mesa.

  • San Diego, including Del Mar, La Jolla, Rancho Santa Fe, Encinitas, Oceanside, and Carlsbad.

  • Palm Springs, including Palm Desert, Rancho Mirage, Indio, La Quinta, and all other parts of the Coachella Valley.

Florida

We serve business owners across Florida’s vibrant cities and regions, from bustling urban centers to coastal communities:

  • Miami, including Miami Beach, Coral Gables, Coconut Grove, Key Biscayne, and the greater Miami-Dade County area.

  • Fort Lauderdale, including Hollywood, Pompano Beach, Weston, Davie, and all of Broward County.

  • West Palm Beach, including Boca Raton, Delray Beach, Jupiter, Palm Beach Gardens, and the entire Palm Beach County area.

  • Tampa, including St. Petersburg, Clearwater, Sarasota, Bradenton, and the broader Tampa Bay region.

  • Orlando, including Winter Park, Kissimmee, Lake Buena Vista, Celebration, and the greater Central Florida area.

  • Jacksonville, including St. Augustine, Ponte Vedra Beach, Amelia Island, and all of Duval and St. Johns Counties.

  • Naples, including Marco Island, Bonita Springs, Estero, and the entire Collier County and Southwest Florida region.

Nevada

Our tax services extend to Nevada’s key business hubs and surrounding communities, supporting entrepreneurs in a tax-friendly state:

  • Las Vegas, including Henderson, Summerlin, North Las Vegas, Boulder City, and the entire Clark County area.

  • Reno, including Sparks, Carson City, Truckee, and the broader Washoe County and Northern Nevada region.

  • Lake Tahoe (Nevada side), including Incline Village, Stateline, Zephyr Cove, and the surrounding South Lake Tahoe area.

  • Henderson, including Green Valley, Anthem, Seven Hills, and nearby communities in the Las Vegas Valley.

  • Elko, including Spring Creek, Carlin, and the greater Northeastern Nevada region.

  • Mesquite, including St. George (nearby Utah border), Bunkerville, and the Virgin Valley area.

  • Pahrump, including Nye County and surrounding rural communities west of Las Vegas.

Tennessee

We support business owners in Tennessee’s dynamic cities and regions, from music hubs to growing entrepreneurial centers:

  • Nashville, including Franklin, Brentwood, Hendersonville, Murfreesboro, and the greater Davidson and Williamson County areas.

  • Memphis, including Germantown, Collierville, Cordova, Bartlett, and the broader Shelby County region.

  • Knoxville, including Farragut, Maryville, Oak Ridge, Sevierville, and the entire East Tennessee area.

  • Chattanooga, including Lookout Mountain, Signal Mountain, Hixson, and the surrounding Hamilton County and Southeast Tennessee region.

  • Clarksville, including Hopkinsville (nearby Kentucky border), Springfield, and the greater Montgomery County area.

  • Johnson City, including Kingsport, Bristol, Elizabethton, and the Tri-Cities region of Northeast Tennessee.

  • Gatlinburg, including Pigeon Forge, Sevierville, and the Smoky Mountains area, catering to tourism-driven businesses.

We are not limited to the above states… Reach out to us! Our contact info is below.