In my experience, smaller businesses providing services are usually best-taxed as S-Corporations. To that point, I advise a lot of my clients to either organize as an S-Corporation directly or have their LLC elect for S-Corporation tax status with the IRS. I also provided insight on the benefits of S-Corps in May of this year; give it a read here.
One of the main benefits of S-Corps I mention in that post is that the net income of the business is not subject to the hefty 15.3% self-employment tax like many other LLCs or Sole Proprietorships. To get this immense benefit, the owners of the S-Corporation must pay themselves a “reasonable salary.” The salary to the owner is subject to the FICA/Self Employment taxes, but profit leftover after the salary is not subject to those additional taxes. Reasonable compensation refers to the amount of salary or wages that a shareholder-employee of said corporation should be paid for the services they provide to the company. If the owner of the S-Corporation does not provide services to the corporation, a salary may not be needed.
Some view the IRS rules as subjective as the word “reasonable” invites different interpretations. The IRS requires that shareholder-employees of S-Corporations be paid a reasonable salary for the work they perform, just as any other employee would be paid for similar services in a similar position in a comparable business. The reasonableness of compensation is essential because it impacts the distribution of profits and the tax liability of the shareholders. If an S-Corporation pays its shareholder-employees an unreasonably low salary, the IRS may reclassify a portion of the distributions made to those shareholders as wages subject to self-employment taxes. This is known as "reasonable compensation recharacterization." Penalties may also be assessed for compensation that is considered unreasonably low.
The perceived subjectivity of “reasonable” has led to abuse by S-Corporation owners. The IRS is now increasingly auditing S-Corporation businesses to ensure that salaries are in fact reasonable. It is not a straightforward analysis, but you will see bulleted below what is considered when determining if owner salary compensation is reasonable.
- Training and experience;
- Duties and responsibilities;
- Time and effort devoted to the business;
- Cost to hire someone else to do the same duties.
Now, how does this translate into documentation for substantiating compensation as reasonable? Documenting factors such as one’s role in the company, one’s responsibilities & qualifications, and the compensation levels of similar positions in other companies within the same industry are paramount. Use of industry salary surveys, market research, and compensation data for similar roles in the applicable region help to justify the chosen compensation level.
As stated, determining reasonable compensation can be subjective. This complexity can result in potential errors and inconsistencies that attract IRS attention. It's important for S-Corporation shareholders to document and support the determination of reasonable compensation utilizing the aforementioned resources, ensuring it aligns with industry standards and the level of services provided. As we look to year-end tax planning, this will be something I keep on our radar. Pigs get fat, hogs get slaughtered. Pay yourself something reasonable if you own an S-Corp. If you’d like to discuss any of this in the interim, please don’t hesitate to reach out.