Reasonable compensation is a critical Tax issue that owners of S-Corporations must consider
What is the problem?
Owners of S-corporations are both shareholders and employees. Businesses compensate them in two ways:
- The business pays distributions to the owners. Distributions are subject to income tax, however, not Social Security or Medicare taxes.
- The business pays wages to the owners. Wages are subject to both sets of taxes.
The IRS requires that wages, at a minimum, meet the standard of “reasonable compensation.” However, the calculation of this standard is frequently subject to debate.
In practice, S-corporation owners prefer to be paid through distributions. This will minimize their tax burden. In contrast, the IRS prefers that S-corporation owners be paid through payroll. This will maximize taxes. Therein lies the conflict.
IRS audits of S-corporations
Shareholder compensation is frequently the subject of IRS audits. Auditors will ask if the company paid sufficient wages to the owners to meet the reasonable compensation standard. This standard hinges on replacement cost, fair market value, job title, and location.
An unsuccessful audit results in additional taxes, interest, and penalties on businesses that fail to meet the reasonable compensation test. This is a risk that few business want to bear.
Therefore, we recommend that our S-corporation clients carefully calculate owner compensation in order to meet the IRS standards. Also, we ask clients to proactively maintain a “reasonable compensation file.” This file can be brought out in the event of an audit.
Additional considerations for reasonable compensation
Finally, maximum contributions to retirement plans are based on wages. If wages are too low, the business owner may miss out on valuable tax deductions and retirement planning.
Give us a call today to discuss a compensation plan that best suits your needs and will keep you out of IRS trouble!
Founded by Gary Massey, CPA, Massey and Company is a boutique CPA firm is located in Atlanta, Georgia serving the needs of small businesses and their owners.
businesses and their owners.