S Corporation Owners: What You Need to Know About Reasonable Compensation
If you own an S Corporation, understanding and acting on reasonable compensation is more important than ever. The IRS has increased its focus on how business owners calculate and report their salaries, and failing to comply could lead to serious consequences. Beyond potential payroll and income tax audits, inaccurate compensation reporting can also impact your future Social Security benefits. Unfortunately, the concept of reasonable compensation is often misunderstood or overlooked during tax planning. This misunderstanding stems from common myths about how compensation should be calculated.
Let’s debunk four of these myths so you can make informed decisions for your business:
Myth #1: The 50/50 Rule is the Best Approach
Many believe that S Corporation owners should split their income 50/50 between salary and distributions. This is simply not true. The IRS requires shareholder-employees to pay themselves a reasonable salary before taking any distributions. To determine what’s reasonable, use one of three IRS-approved methods:
1. Cost Approach: Based on time and tasks performed.
2. Market Approach: Compares compensation to industry standards.
3. Income Approach: Considers the business’s profits and the owner’s role. Relying on a flat 50/50 split doesn’t meet IRS guidelines and could result in penalties.
Myth #2: Industry Norms Alone Determine Reasonable Compensation
It’s a mistake to base reasonable compensation solely on what others inyour industry are paying. While industry benchmarks can provide a reference point, they don’t account for the unique responsibilities or qualifications of each business owner. A tailored analysis ensures your compensation aligns with IRS expectations.
Myth #3: Low Compensation Minimizes Taxes
Some believe paying a lower salary reduces taxes, but this strategy can backfire. Underpaying yourself increases the risk of an IRS audit, which could lead to costly penalties. Using data-driven, IRS-defensible methods to calculate reasonable compensation not only keeps you compliant but also protects your financial future.
How to Stay Compliant:
The IRS recognizes three methods for calculating reasonable compensation: the Cost, Market, and Income approaches . Whichever approach you choose, keep detailed documentation to support your. decision. This reduces your audit risk and demonstrates good faith compliance with tax laws. Reasonable compensation is not just a tax obligation—it’s a way to safeguard your business and financial well-being. If you’re unsure about your compensation strategy, consult with your tax advisor to ensure you’re on the right track.
