The IRS is turning its attention to S-Corporations (S-Corps) and the salaries paid to shareholder-employees. Ensuring that you are paying yourself a “reasonable compensation” is crucial to staying compliant with the law and avoiding potential financial consequences. At Molen & Associates, we have introduced a program to help you navigate this complex issue, providing valuable insights and generating comprehensive reports based on IRS-approved approaches. In this article, we will explore the importance of reasonable compensation, how to calculate it, and the consequences of not adhering to IRS guidelines.

What is Reasonable Compensation?

Reasonable Compensation is a critical concept for S-Corp owners to grasp. According to the IRS, it is defined as “the value that would ordinarily be paid for like services by like enterprises under like circumstances” (IRS Code: Section 162-7(b)(3)). In simpler terms, it means determining how much compensation a non-owner in a similar role at a comparable company would receive in an arm’s-length employment relationship.

Key Points to Remember:

Reasonable Compensation is based on the service’s value, not the company’s profits or distributions.

1. Wages (Reasonable Compensation) should be paid before any distributions, and they must be paid via W-2.
2. Shareholder-employees can receive wages without taking a distribution, but not the other way around. You can “catch up” on compensation in a later year if needed.

Calculating Reasonable Compensation

The IRS recognizes three approved approaches to calculate Reasonable Compensation: the Cost Approach, Market Approach, and Income Approach. The choice of approach depends on your business’s specific circumstances, and your accounting professional can help you make an informed decision.

Helpful Tips for Calculating Reasonable Compensation:

1. Perform a Reasonable Compensation analysis annually. Compensation standards change over time, so it’s essential to keep your figures up to date.

2. Document your Reasonable Compensation calculations meticulously. Maintain records of all data sources and calculations used to arrive at your figure. This documentation is vital if you are ever audited.

3. Use unbiased data sources. In an audit, the IRS will scrutinize your data sources to ensure they are unbiased and accurate. Opt for reliable sources like the Bureau of Labor Statistics and the U.S. Census Bureau, as websites like Glassdoor and Payscale may be considered biased due to their reporting methods.

Consequences of Not Taking Reasonable Compensation

Failing to pay yourself reasonable compensation while taking distributions from your S-Corp can lead to significant financial repercussions. The IRS may impose back taxes, penalties, and interest. Moreover, your S-Corp status could be revoked, and preparer penalties may be levied against your tax accountant.

In essence, if you have chosen to file as an S-Corp, it is essential that all shareholder-employees receive a reasonable salary via W-2 before any distributions are made.

Additional Responsibilities of S-Corp Owners

While S-Corps offer various tax benefits, they come with additional responsibilities:

1. S-Corp shareholder-employees must pay themselves reasonable wages (Reasonable Compensation) through W-2 before taking distributions.
2. You must file an additional tax return for your business as an S-Corp.
3. Some states may impose additional fees on S-Corps.
4. There may be filing fees associated with becoming an S-Corp.

If you are unsure whether an S-Corp structure is suitable for your business, give us a call to perform an Entity Planning Analysis. This analysis will help determine the best approach for your specific situation.

Conclusion

Paying yourself reasonable compensation as an S-Corp shareholder-employee is not only a legal requirement but also essential for maintaining your financial health and avoiding IRS penalties. Molen & Associates’ program can assist you in calculating your reasonable compensation using IRS-approved methods. By following these guidelines and staying informed, you can ensure that your S-Corp remains compliant with the law while enjoying the tax benefits it offers. Don’t risk the consequences—prioritize reasonable compensation and protect your S-Corp’s status and your financial future.

Whether you’re a new business looking to set the right course from the beginning, an existing business owner who needs to start taking a wage, or simply want to safeguard your business from potential IRS scrutiny, Molen & Associates is here to assist you. Our experts can perform an annual analysis tailored to your unique situation, ensuring that you stay on the right side of the law and maximize the benefits of your S-Corp structure. Don’t hesitate to reach out to us today and take the proactive step towards financial security and compliance. Call us now to schedule your Reasonable Compensation analysis and protect your business’s future. Your peace of mind is just a call away.