S-corporations are a popular choice among small business owners. They offer a range of tax benefits, such as avoiding double taxation and passing profits and losses onto shareholders. However, S-corporation shareholders must ensure they receive reasonable compensation for their services to the corporation to avoid triggering tax penalties from the Internal Revenue Service (IRS).
What Is Reasonable Compensation?
Reasonable compensation is the payment a shareholder receives for their services to the S-corporation. The compensation must be based on the value of the services provided and be comparable to what an unrelated party would pay for similar services. The IRS looks closely at this to ensure that shareholders do not avoid paying payroll taxes by taking a lower salary and distributing more profits as dividends.
Why Is Reasonable Compensation Important?
S-corporation shareholders can reduce their tax liability by taking a lower salary and distributing more profits as dividends. However, if the salary is unreasonably low, the IRS can reclassify the dividends as salary and assess back taxes, interest, and penalties on the corporation and the shareholder.
The IRS determines reasonable compensation based on several factors, including the shareholder’s role in the business, their responsibilities, their experience, and their education. Shareholders who are actively involved in the day-to-day operations of the business should receive a higher salary than those who are passive investors.
How To Determine Reasonable Compensation
Determining reasonable compensation can be challenging as it requires considering multiple factors, such as industry standards, experience, education, and responsibilities. The following are some methods that S-corporation shareholders can use to determine reasonable compensation:
Industry compensation surveys
Industry compensation surveys can provide useful benchmarks for determining reasonable compensation. These surveys collect data on compensation for specific job titles and industries, providing a baseline for comparison. S-corporation shareholders can use these surveys to determine what the market rate is for their specific role and adjust their salary accordingly.
S-corporation shareholders can compare their salary to what an unrelated party would pay for a similar role. This approach requires research into job postings and salary data for similar roles in the industry. Shareholders can then use this information to adjust their salary based on their level of experience and responsibilities.
S-corporation shareholders can perform a financial analysis to determine reasonable compensation. This approach requires calculating the value of the services provided by the shareholder and comparing it to the compensation they receive. Shareholders can use financial ratios, such as return on assets, to determine if their compensation is reasonable.
S-corporation shareholders can hire a professional appraiser to determine reasonable compensation. A professional appraiser can provide an independent evaluation of the shareholder’s role in the business, their responsibilities, and their experience. This approach is useful when the shareholder has a unique role or has specific skills that are difficult to quantify.
What Are The Consequences Of Unreasonable Compensation?
The consequences of unreasonable compensation can be severe for S-corporation shareholders. If the IRS determines that the shareholder’s salary is unreasonably low, they can reclassify dividends as salary and assess back taxes, interest, and penalties. Shareholders can also face legal action from the IRS, which can result in significant fines and legal fees.
Furthermore, unreasonable compensation can also affect the shareholder’s ability to obtain financing or sell the business. Lenders and buyers often review the financial statements of the business and may view unreasonably low salaries as a sign of financial instability.
S-corporation shareholders must ensure they receive reasonable compensation for their services to the corporation to avoid triggering tax penalties from the IRS. Determining reasonable compensation can be challenging, as it requires considering multiple factors, such as industry standards, experience, education, and responsibilities. S-corporation shareholders can use industry compensation surveys, comparable salaries, financial analysis, and professional appraisals. If you need any assistance with this, please feel free to contact our team at Whittaker. Click the link below to get started today.