For small businesses formed as an S Corporation and with plenty of profits, reasonable compensation is a term you may want to be familiar with.
Many small businesses have organized as an S Corporation form of entity. This allows business owners to save money on self-employment taxes, especially if they operate as a sole proprietor. In addition, S Corp profits, or distributions, are not subject to payroll taxes.
If you’re taking a salary and contributing substantially to your business’s operations, you may think you should just take the distributions and forget the salary. After all, think how much you would save in payroll taxes! But the IRS has already fought this idea in the courts, and won every single time. This is where the term “reasonable compensation” comes in.
The IRS requires owners who contribute substantially to the business pay themselves a salary according to a number of guidelines. This is what we’re referring to when we talk about reasonable compensation. You can’t pay yourself below market and take a large amount in distributions.
The IRS has issued a fact sheet that describes the guidelines that can be used to determine reasonable compensation. They include employee training, experience, duties, time spent, history of distributions, and bonuses. The cases the IRS has fought in court enumerate a number of important factors as well.
There are also reasonable compensation ramifications for C Corporations as well.
If reasonable compensation is an issue or concern for your business, please contact us at Innovative Financial Services, LLC today and let us know how we can help.
(“Compensation” by Nick Youngson is licensed under CC BY-SA 3.0)