Many business owners appear to misunderstand the S Corp election, and reasonable compensation is often overlooked or not approached correctly. Before we dive in, some things should be noted.
When considering an S Corp election, two crucial factors must be assessed: conducting a reasonable compensation study and creating an entity analysis. It is vital to ensure that your tax professional conducts these evaluations before suggesting an S Corp election. Failure to do so may result in improper tax advice. Now, let’s focus on the concept and requirements of reasonable compensation.
The S Corporation Election Acceptance Letter from the Internal Revenue Service (IRS) provides guidance on reasonable compensation. This letter emphasizes the importance of determining a reasonable salary for shareholder-employees of an S Corp. Payments to shareholder-employees for services rendered are considered wages and subject to employment taxes. In cases where distributions are made in lieu of reasonable compensation, the IRS has the authority to recharacterize them as salaries. Shareholders must also track their stock and debt basis to ensure compliance. While the latter part of the letter touches on basis, we will primarily focus on reasonable compensation requirements in this episode.
When the IRS defines reasonable compensation, it refers to compensation comparable to what one would receive for similar work performed elsewhere. This assessment takes into account the tasks performed by the shareholder-employee, including low-value tasks, in addition to their primary job within the business. To determine reasonable compensation, the cost approach or “many hats” approach is commonly used. This involves evaluating all tasks performed in the business based on a 40-hour workweek or 2,080 hours per year. Labor statistics specific to the geographic area are considered, and the values for each job and task are combined to determine the total compensation. It’s important to note that reasonable compensation cannot be determined simply by net income or by a percentage of profits.
Reasonable compensation and shareholder distributions
The IRS primarily focuses on reasonable compensation when it comes to distributions taken by S Corp owners. An advantage of an S Corp is the ability to receive both a salary and distributions from the business. However, distributions can only be taken once a reasonable salary has been paid, and sufficient basis or equity is available in the business. If the distribution exceeds reasonable compensation or is taken without meeting these requirements, the IRS can recharacterize the distribution as payroll and impose penalties, interest, and payroll taxes. It is crucial to maintain the proper relationship between reasonable salary and distributions.
It is essential to strike the right balance with your salary. Keeping your salary too high can be just as problematic as keeping it too low. Inflating your salary to minimize taxes may lead to scrutiny from the IRS and fee and penalties due to recharacterized distributions. A reasonable compensation study becomes crucial in determining the exact amount that should be paid. Additionally, paying yourself a reasonable salary is essential for retirement planning and social security benefits. Underpaying yourself might result in smaller benefits when you retire. So, while minimizing tax burden is important, it’s equally crucial to consider long-term financial security.
Taking Corrective Measures
S corporation owners who are unsure about the reasonableness of their compensation should seek professional assistance. Many accounting firms, including yours truly offer reasonable compensation studies, which employ the same approaches used by the IRS in audits. These studies provide valuable insights and help ensure compliance with IRS regulations. If discrepancies are identified, corrections can be made to bring compensation in line with the requirements.
If S corporation owners realize that their compensation is not reasonable or has been incorrectly reported, there are steps they can take to rectify the situation. Seeking the assistance of a payroll service can help reconstruct compensation figures, allowing the necessary adjustments to be made. This can involve recategorizing previous distributions as reasonable compensation and paying the required payroll taxes. In some cases, increasing salary throughout the year can also help align it with the reasonable compensation figures obtained in the study.
If you or anyone you know is looking to make sure their compensation is reasonable, we can help by conducting a reasonable compensation study.