If you’re an officer-owner of an S corporation, it’s crucial to recognize how the IRS views your compensation. As an employee of your corporation, you are required to pay yourself a wage that is deemed “reasonable” for the work you perform. But what does “reasonable” really mean? It refers to a wage that corresponds to the value of your role, responsibilities, and the time you dedicate to the business—similar to what another company would pay for similar work.
What Does “Reasonable Compensation” Mean?
The IRS evaluates whether your salary is “commensurate with your duties.” Put simply, your compensation should reflect:
- The work you perform
- Your time on the job
- What similar businesses pay for comparable roles
To aid in determining reasonable compensation, the IRS considers a variety of factors including the following.
- Your training and experience
- Your duties and responsibilities
- The time and effort you devote to the business
- The historical payment of dividends
- Compensation for non-shareholder employees
- Timing and nature of any bonuses
- Salary data from comparable businesses
- Any compensation agreements or formulas you may have
Step-by-Step Guide to Determine Your Reasonable Compensation
- Map Your Role and Time
Begin by outlining your specific duties, which may include sales, management, or technical work. Estimate how many hours you work each week and assess how critical your role is to the company’s revenue and operations. - Research Market Pay
Investigate salary data for similar positions in companies of comparable size in your area. If you handle multiple functions, apportion your time accordingly and blend the respective pay rates as needed. - Consider Your Company’s Pay Patterns
If you often take larger distributions from the business, ensure that your wage compensates adequately for the value of your services. Compare your salary to that of non-owner employees who perform similar work. - Set a Defensible Salary
Use your research findings to establish a salary figure that accurately reflects your duties, time investment, and market comparables. If cash flow is tight, it’s acceptable to adjust bonus payouts; however, never forgo paying a wage altogether, as distributions cannot substitute for wages. - Run Payroll Correctly
Ensure that wages are processed through payroll, with appropriate taxes withheld, including income tax, Social Security, and Medicare. Don’t forget to issue yourself Form W-2 as an officer-employee. - Report Officer Compensation
If your S corporation’s total receipts exceed $500,000 and you are deducting officer pay, attach Form 1125-E (Compensation of Officers) to your 1120-S tax return.
Special Note on Health Insurance for >2% Shareholders
If your S corporation pays health insurance premiums for shareholders who own more than 2%, remember that those premiums should be included in Box 1 of your W-2 for income tax purposes. Because this will not be subject to FICA taxes, this amount will not appear in Boxes 3 or 5 of your W-2.
Common Pitfalls to Avoid
- Paying Little or No Wages: Taking large distributions without corresponding wages can lead the IRS to classify those distributions as wages and impose payroll taxes and penalties.
- Ignoring Payroll Tax and W-2 Requirements: Remember, officers are considered employees. Wages must go through payroll, complete with withholding.
Bottom Line
Setting a wage that fairly reflects the services you provide is essential for compliance. Your wage should be based on your time investment, duties and responsibilities, your training and experience, and salary data from comparable businesses and it should be paid through proper payroll channels with the necessary withholding.
Keep thorough records of how you determined this wage, including salary surveys, duty summaries, and time estimates, and always treat distributions as returns on your ownership stake—not as substitutes for your salary.
If you have any questions or need assistance in determining your reasonable compensation, feel free to reach out. We’re here to help you navigate this important aspect of your S corporation!
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