What is Reasonable Compensation for an Active S Corporation Shareholder?

What is Reasonable Compensation for an Active S Corporation Shareholder?

By David Kaplan, CPA

Reasonable Compensation is always a big question when it comes to S Corporations.  When a potential business owner is determining what type of entity to create, one of the factors in making that decision is knowing what amount of the net income will be subject to self-employment tax.  Self-employment tax is in addition to federal and state income taxes.  It is the employee and employer portions of the Social Security and Medicare Tax, also known as the Federal Insurance Contribution Act (FICA) Tax, that is 15.3% of gross wages or self-employed income up to certain limitations.  While compensation is not the only factor to consider, creating an S Corporation gives you the flexibility to determine what income is subject to self-employment tax by declaring a salary, as long as it’s deemed reasonable compensation.

The IRS does not have any official calculation to determine what reasonable compensation is, but there are some factors it lists that can be considered:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of a formula to determine compensation

Every company will be different, and the circumstances will need to be evaluated for your own situation.  For example, if you’re the sole owner actively running a new S Corporation, experiencing first year losses or a minimal income, all of which is going back into the company and not into your own pocket, then it’s reasonable that you would have little or no salary to report.

Consider another example of an S Corporation having one shareholder, who is actively running the company.  At the end of the year, the company had net income of $300,000.  Of that, $200,000 was available to be paid to the shareholder.  Now a reasonable compensation would need to be determined.  If only $30,000 of that $200,000 was declared as salary, that could raise flags with the IRS, as it would be viewed that your duties and responsibilities are the driving force of the income earned, and it would want the company to prove how it determined $30,000 to be reasonable compensation.    So, how should a reasonable compensation be determined?

The recommended course of action would be to research job sites as to what similar industries pay for doing the same type of responsibilities and duties in your area.  Save copies of your research.  Project if the company is expected to have the profits to support the compensation from your research.  If so, then declare a salary in that range.  If not, determine a formula for your compensation based on funds you will be able to distribute to the shareholder employee.  While there is not a rule provided by the IRS, a common approach is to establish a specific ratio on funds available to distribute back, such as a 50-50 approach, of which 50% is allocated to salary and 50% is a distribution.  When applying this standard to the 2nd example with $200,000 available to be distributed to the shareholder, $100,000 would be allocated to salary (50%) and $100,000 would be a distribution (50%).

Another consideration, when profits and amounts available to be paid to shareholders are relatively high, is to pay a reasonable salary based on the maximum salary subject to the Social Security tax for the year.  The maximum amount of salary subject to Social Security tax in 2018 is $128,700.  While the benefit of paying this salary may be minimal from having all of your net income subject to self-employment tax, you would still be saving on the Medicare portion, which has no cap and can be viewed as a good-faith effort to pay in an appropriate share of the FICA Taxes.

It is also important to note that the amount of salary reported on a shareholder’s W-2 will play an important role in the calculation of the new qualified business income deduction that was passed as part of the Tax Cuts and Jobs Act. This deduction is available starting in 2018.

Each S Corporation will have to look at its facts and circumstances.  Please contact your tax advisor if you want to review your compensation from your S Corporation to see if you’re taking the appropriate steps to report a reasonable compensation.

David Kaplan

David Kaplan Tax Senior Manager, CPA

NC License #39658 FL License #AC39298