By Laura Johnson, EA

The owner of a corporation, who performs services for the corporation, is an employee and must take a salary. Furthermore, that salary must be considered reasonable. A business will owe tax, penalties, and interest if the IRS finds that the owner did not take a reasonable salary.

In S corporations, shareholders generally wish to receive low compensation, to save on associated payroll taxes. In C corporations, shareholders often want to receive high compensation, to pull profits from the corporation without triggering a tax on dividends. In either context, the IRS can challenge compensation as unreasonably high, or unreasonably low. Therefore, it is important to be ready to justify your company’s compensation policy.

What is reasonable? 

Several factors should be considered in assessing whether compensation is reasonable. 

First you might look at the corporation's gross receipts and consider their source. Do they come from services of the owner, services performed by other employees, or capital and equipment? The higher percentage that come from services of the owner, the higher you’d think a reasonable compensation would be.

But those aren’t the only factors. Think about:

-the shareholder-employee’s duties

-the amount of time required to perform those duties

-complexity of the business

-the business’s net and gross income

-the employee’s ability and accomplishments as well as compensation history

-the general salary policy if the company has other employees

Consider the market in which you are located. Reasonable compensation in an area with a high cost of living would be greater than in a lower cost of living jurisdiction. Consider the going market rate that you would have to pay a third party to perform the same tasks as the owner. If the going rate was $100,000 for that position, but you are paying the S-corporation owner, $25,000, could that compensation be justified as reasonable? Probably not. Likewise, if the going rate was $50,000, but you are paying a C corporation owner $200,000, is that reasonable? You’d better be ready to say why you think so.

Look at what is unreasonable

We tell our clients that reasonable compensation is $1 more or less than unreasonable compensation. It’s a sort of smell test. If someone would laugh at what you're offering to a third-party candidate for a job and that is exactly what you are paying yourself, you have a strong indication that salary is unreasonable. If someone would consider taking the job at what you were paying yourself, then you probably have a stronger leg to stand on.

The job matters

The services performed by the corporation owner-employee are relevant in this analysis. An owner working full-time, consistently, to run the business would very likely need to be compensated more than a part-time owner who has a full-time staff running the business for her. 

At John Schachter + Associates, we help our clients set reasonable compensation. Let us know if we can help you.