S-Corps are required to pay “reasonable compensation” to shareholders in return for services provided by the shareholder BEFORE non-wage distributions may be made to the shareholder (IRS). Determining what constitutes reasonable compensation has been a question for many S-Corps and C-Corps alike, and the answer to that question can have significant tax implications.
For many years tax professionals told clients that the way to deal with IRS restrictions on reasonable compensation was to pay themselves 60% of their overall compensation as W2 income and the other 40% as a distribution. However a close look at the actual court cases involving reasonable compensation paints a different story of the detail required by the IRS for justifiable compensation. Whether you are an S-Corp or a C-Corp, reasonable compensation must meet key criteria, be comparable to industry standards, and be well documented (Thomas A. Gorczynski, EA, USTCP).
The 60-40 rule suggests that S-Corp owners take 60% of their overall compensation as a salary and the remaining 40% as distributions. This is not and has never been an official IRS rule but was widely shared as a guideline by accountants to their clients. If one looks at the actual court cases involving reasonable compensation over the last two decades it becomes clear that the IRS is looking for way more detail than the 60-40 rule alone (RCReports – Reasonable Compensation Simplified).
The 60-40 rule grew in popularity hand in hand with S-Corps as a way to lower tax liability through splitting the desired compensation between wages and distributions. Here is how it works in simple terms. Wages – 60% of your desired compensation is paid as salary which is subject to both the employee and employer side of Medicare and social security taxes and taxed at your individual income tax rate. Distributions – 40% of your desired compensation is paid as a distribution which is not subject to any Medicare or social security taxes. Using the 60-40 rule, S-Corp owners were able to lower their overall tax liability.
The latest thinking in the tax professional field is that following the 60-40 rule will not fully protect your business from penalties that could be incurred as a failure to pay yourself a reasonable compensation as a salary (Journal of Accountancy). We, along with a growing number of tax professionals, are recommending a more encompassing and audit ready approach to minimizing your tax burden using reasonable compensation.
Reasonable compensation for S-Corps needs to be determined on a case by case basis keeping in mind the following key points: nature of the work, comparable positions, experience and qualifications, company profits, documentation of how this number is reached, and regular reviews (RCReports – Reasonable Compensation Simplified). The reasonable compensation for the owner of an S-Corp should be defensible and documented in preparation of any audit. “I was following the 60-40 rule” is not going to pass IRS audit standards.
Here is a breakdown of some of the key points you should consider when determining reasonable compensation for your S-Corp:
When dealing with reasonable compensation, it is recommended to enlist the help of a tax professional for tracking these criteria and establishing a proper level for compensation. It is important to remember that the Inflation Reduction Act of 2022 included $45.6 Billion in IRS funding to increase enforcement along with a plan to hire a large number of additional tax agents. We believe S-Corps are likely to be targets of this additional scrutiny.
In C-Corps the level of scrutiny by the IRS on reasonable compensation is seen to be lower than in S-Corps. Nonetheless, it is important to pay close attention to the compensation for officers and executives and pay them a justifiable salary as well. In particular, the IRS is looking to determine if the salary is excessive (Thomas A. Gorczynski, EA, USTCP). The concern here is that excessive pay to the owners will reduce the net profit of the corporation and lead to less corporate tax being paid, thereby removing the challenge of double taxation.
Here are some key points worth considering to determine reasonable compensation for C-Corps:
Size of type of business
Much of the reasoning behind these criteria for C-Corps is the same as S-Corps. However, it is important to note that reasonable compensation is indeed expected for C-Corps in the same way it is required for S-Corps.
Well, you will have to calculate that out. Using the above mentioned key points, determine what another company might pay for an exact replica of you and then consider the profitability of your unique business. Document all of these steps and the analysis that brings you to your final number. Reevaluate this number consistently and update it as needed. Finally… hire a tax professional! In the process of maintaining compliance with reasonable compensation, it is likely you will find yourself with a different tax situation than you are prepared to deal with alone.
