What is Reasonable Compensation? A Primer for S-Corp Owners
Written by: Megan Ramey, CPA, ABV
Recently we were engaged to assist a family-owned business with consulting and advisory services with regard to their pay practices amongst family members who were employed by the Company. We refer to this as a Reasonable Compensation Analysis.
Reasonable Compensation in a Nutshell
All S-Corp shareholder-employees must pay themselves a reasonable wage (i.e., Reasonable Compensation) via a W-2 before any distributions are taken. It’s the law.
You should complete a Reasonable Compensation analysis each year using one of the three IRS-approved approaches.
Records of all supporting documentation need to be kept evidencing your analysis each year.
What is Reasonable Compensation?
The biggest struggle for most S-Corp owners is defining Reasonable Compensation. The IRS defines Reasonable Compensation as: the value that would ordinarily be paid for like services by like enterprises under like circumstances. ~ IRS Code: Section 162-7(b)(3).
To put it in simpler terms, you can ask yourself, “How much compensation would be paid for this same position, held by a non-owner in an arms-length employment relationship, at a similar company?”
A few things to keep in mind:
Reasonable Compensation is based on the value of the service provided, not profits or distributions.
Wages (i.e., Reasonable Compensation) should be paid before distributions and must be evidenced via an annual W-2 statement.
A shareholder-employee can take wages without taking a distribution, but not vice versa.
A shareholder-employee who does not want to take Reasonable Compensation can refuse all compensation and play “catch-up” in a later year.
Reasonable compensation figures include taxable Medicare wages and flexible spending accounts. Reasonable compensation figures do not include non-taxable fringe benefits such as health insurance, vehicle or vehicle allowance, stock options, company loans and other items not reported on a W-2 as Medicare wages.
How do You Calculate Reasonable Compensation?
The IRS defines three approved approaches to calculate Reasonable Compensation: The Cost Approach, the Market Approach, and the Income Approach. Each approach is useful in different situations and Cogence Group can help determine the appropriate approach to use based on your business.
Here’s how Cogence Group can help when it comes to Reasonable Compensation:
We can run a Reasonable Compensation analysis every year. Just like wages can change over time, so can Reasonable Compensation. What was considered reasonable 5 years ago is most likely no longer accurate.
We document your Reasonable Compensation figure. We keep a record of all data used and all calculations completed to arrive at your Reasonable Compensation figure each year. This will come in handy should you ever be audited.
We use unbiased data. If you are ever audited, the IRS will be looking to see that you used unbiased data for your calculations – that is, data that is not influenced by an interested party and meets criteria to be determined accurate. Often sites like Glassdoor and Payscale are considered biased because the sample sizes and reporting methods can result in inaccurate data. We use unbiased sources such as the Bureau of Labor Statistics and the U.S. Census Bureau.
What Happens if I Don’t Take Reasonable Compensation?
If you don’t take Reasonable Compensation but you do take distributions from the business, you are opening yourself up to potentially large financial consequences including back taxes, penalties, and interest levied by the IRS. The IRS can also revoke your S-Corp status and they have been known to levy preparer penalties on tax preparers (i.e., your tax accountant).
In conclusion, deciding what’s reasonable for a business owner to receive as compensation can be subjective and sensitive. This is because what is considered a reasonable level of compensation by the individual or S-Corp is often considered unreasonable by the IRS. Our firm can serve as an expert to research comparable, unbiased market data and use it to come up with a defensible estimate. Stop guessing and call Cogence Group today to help you with your Reasonable Compensation analysis!