For small businesses formed as an S Corporation and with plenty of profits, reasonable compensation is a term you may want to be familiar with.
Many small businesses have organized as an S Corporation form of entity. In many cases, the S Corp election allows a business owner to save money on self-employment taxes, especially if they are operating as a sole proprietor. S Corp profits, or distributions, are not subject to payroll taxes.
Why not just take distributions?
If you are a business owner taking a salary and contributing substantially to the operations of the business, you may think that you should just take the distributions and forget the salary. After all, think how much you would save in payroll taxes. But this has already been tried and shot down by the IRS in the courts. And this is where the term reasonable compensation comes in.
The IRS requires that business owners that perform a substantial contribution to the business be paid a salary according to a number of factors. This is called reasonable compensation. You can’t pay yourself below market and take a large amount in distributions.
The IRS has issued a fact sheet that describes the guidelines that can be used to determine reasonable compensation. They include employee training, experience, duties, time spent, history of distributions, bonuses, and many other factors.
There are also reasonable compensation ramifications for C Corporations as well.
If reasonable compensation is a concern for your business, talk it over with your CPA. If you have any other questions with your ongoing bookkeeping, we’re here to help!