Key Takeaways
Pay Yourself Fairly: The IRS requires S-Corp owners to pay themselves a salary that matches market rates for their role.
Avoid Penalties: Failing to follow the rule can lead to IRS audits, back taxes, fines, and even the loss of your S-Corp status.
Balance Salary and Distributions: Pay yourself a reasonable salary first, then take distributions to minimize self-employment taxes.
Document Everything: Keep detailed records of how you determined your salary to prove compliance.
Consult Professionals: Work with a tax advisor or CPA to ensure you’re following the rules and avoiding mistakes.
Running an S-Corporation (S-Corp) comes with its own set of rules, and one of the most important is the IRS’s reasonable compensation rule. This rule ensures that S-Corp owners pay themselves a fair salary for the work they do. Ignoring this rule can lead to penalties, audits, or even the loss of your S-Corp status. Here’s what you need to know to stay compliant and avoid trouble.
What Is the Reasonable Compensation Rule?
The reasonable compensation rule requires S-Corp owners who work in their business to pay themselves a salary that aligns with what someone in a similar role would earn in the market. The goal is to prevent owners from avoiding payroll taxes by taking distributions (which are taxed differently) instead of a proper salary.
Why Does This Rule Matter?
This rule isn’t just a formality—it’s a critical part of running an S-Corp. Here’s why:
Tax Compliance: The IRS closely monitors S-Corps to ensure owners aren’t skipping payroll taxes by taking distributions instead of salaries.
Avoiding Penalties: If you don’t pay yourself a reasonable salary, the IRS may reclassify your distributions as wages. This could mean owing back taxes, penalties, and interest.
Financial Health: Paying yourself fairly reflects the true financial health of your business and ensures accurate financial reporting.
How Do You Determine a Reasonable Salary?
Figuring out what’s “reasonable” can be tricky, but here are some key factors to consider:
Industry Standards: Research what others in your field are earning. Websites like Salary.com or the Bureau of Labor Statistics can provide helpful benchmarks.
Your Role and Responsibilities: The more responsibility you have, the higher your salary should be.
Time Invested: The number of hours you work plays a role in determining a fair salary.
Business Profits: If your business isn’t making much money, it might limit how much you can pay yourself.
Salary vs. Distributions: What’s the Difference?
S-Corp owners can receive both a salary and distributions, but there’s a key distinction:
Salary: This is subject to payroll taxes (Social Security and Medicare) and must be reasonable based on your role.
Distributions: These are not subject to self-employment taxes, which is why some owners try to minimize salaries and maximize distributions. However, this can raise red flags with the IRS.
The IRS requires you to pay yourself a reasonable salary first before taking distributions. Striking the right balance is key to staying compliant.
Common Misconceptions About Reasonable Compensation
There are a few myths about this rule that can get business owners into trouble:
The 50% Rule: Some think paying themselves 50% of the business’s profits is enough. This isn’t true—salaries should reflect market rates, not arbitrary percentages.
Part-Time Work Means Lower Pay: Even if you work part-time, your salary should still reflect the value of your work, not just the hours you put in.
Business Losses Justify Low Salaries: Even if your business isn’t profitable, you still need to pay yourself a reasonable salary.
Best Practices for Staying Compliant
To avoid trouble with the IRS, follow these tips:
Document Everything: Keep detailed records of how you determined your salary, including industry research and job responsibilities.
Review Annually: Adjust your salary as your role, responsibilities, or market conditions change.
Consult a Professional: A tax advisor or CPA can help you navigate the rules and avoid costly mistakes.
What Happens If You Don’t Follow the Rule?
Ignoring the reasonable compensation rule can lead to serious consequences:
IRS Audits: The IRS may scrutinize your business and reclassify distributions as wages.
Fines and Penalties: You could owe back taxes, plus interest and penalties.
Loss of S-Corp Status: In extreme cases, your business could lose its S-Corp status, which would mean higher taxes and less flexibility.
Why Compliance Matters
Following the rule isn’t just about avoiding penalties—it’s about maintaining your business’s financial health and credibility. Paying yourself a fair salary helps with:
Financial Planning: A reasonable salary ensures better cash flow management.
Building Trust with the IRS: Compliance reduces the risk of audits and disputes.
Protecting Your Business: It safeguards your S-Corp status and avoids legal issues.
How to Determine a Reasonable Salary
To figure out what’s reasonable, follow these steps:
Research Industry Salaries: Use tools like the Bureau of Labor Statistics or salary surveys.
Consult a Professional: A CPA or tax advisor can help you stay compliant.
Document Your Process: Keep records of how you arrived at your salary figure, including market studies and job descriptions.
Struggling to determine a reasonable salary for your S-Corp? Let CentsIQ simplify the process for you! Our expert team specializes in S-Corp compliance, ensuring you stay on the right side of the IRS while maximizing your tax benefits. Schedule a free consultation today and take the guesswork out of reasonable compensation—so you can focus on growing your business with confidence