Stay Ahead of Law Changes & Protect Yourself Against Being Audited: Corporate Transparency Act and Reasonable Compensation

What If an S Corp Owner Can’t Pay Reasonable Compensation?

What If an S Corp Owner Can’t Pay Reasonable Compensation?

One of the most common questions we receive from S corporation owners is:

“What happens if I can’t afford to pay myself reasonable compensation?”

The answer is both simple and complex. While business owners often think reasonable compensation is tied to profit or loss, the reality is that it’s linked to distributions.

Let’s break it down.

Understanding Reasonable Compensation

The IRS defines reasonable compensation as:

“The value that would ordinarily be paid for like services by like enterprises under like circumstances.”

In simpler terms, this is what it would cost to replace you with someone else doing the same job.

Key points to remember:

  • Reasonable compensation is based on the value of services provided, not on profits, distributions, or what the company can afford to pay.
  • Wages (reasonable compensation) must be paid before taking any distributions.
  • An S Corp owner can choose to take a salary without a distribution, but not the other way around.
  • If an S Corp owner doesn’t want to take reasonable compensation, they must also decline all distributions and can potentially “catch up” in a later year.

Scenario 1: Profitable Business with Distributions

James Carter owns 100% of Carter Construction, an S Corp.

  • 2022 net profit: $187,000 (before owner salary)
  • James’s reasonable compensation: $78,950
  • James wants to withdraw as much cash as possible.
  • After consulting with his CPA, he elects to withdraw $175,000.

How This Plays Out:

  • James pays himself $78,950 in wages.
  • He takes the remaining $96,050 as a distribution.

💡 Key takeaway: James followed IRS guidelines by paying himself reasonable compensation first, then taking a distribution.

Scenario 2: Business Profits Below Reasonable Compensation

Same business, different year.

  • 2023 net profit: $43,000 (before owner salary)
  • James’s reasonable compensation: $78,950
  • James wants to withdraw $50,000 from the company.

How This Plays Out:

  • James takes $50,000 as wages.
  • No distribution is allowed because reasonable compensation must be met first.

💡 Key takeaway: If the business isn’t making enough to cover reasonable compensation, the owner can take what’s available as wages but cannot take a distribution.

Scenario 3: No Distributions, No Salary

  • 2022 net profit: $187,000
  • James’s reasonable compensation: $78,950
  • He elects to take no distributions.

How This Plays Out:

  • James takes $0 in wages and $0 in distributions.

💡 Key takeaway: The IRS does not require S Corps to make distributions. Since James didn’t receive a distribution, he wasn’t required to take reasonable compensation.

But what happens if James wants to “catch up” on compensation later?

Scenario 4: Multi-Year Compensation Strategy

  • 2022 net profit: $187,000
  • James takes no salary and no distribution.
  • 2023 net profit: $220,000
  • James wants to take $400,000 from the business.

How This Plays Out:

  • Because James skipped his 2022 reasonable compensation, he must pay himself for both years before taking a distribution.
  • His salary for 2023 = $157,900 (covering both years).
  • The remaining $242,100 can be taken as a distribution.

💡 Key takeaway: The IRS allows multi-year compensation adjustments, but the owner must pay back wages before taking distributions.

Scenario 5: Business Loses Money, But Reasonable Compensation Still Applies

  • 2019: James loans his S Corp $60,000 to keep it afloat.
  • 2020: The business earns $17,000.
  • James takes $30,000 back from the business.

Two Possible Outcomes:

✔️ If James properly classified his $60,000 as a loan

  • The $30,000 repayment is simply paying himself back—no impact on reasonable compensation.

If James didn’t properly document the loan

  • The IRS may treat the $30,000 as a distribution—which means James should have first paid himself reasonable compensation.
  • To comply, he must reclassify $30,000 as wages and pay payroll taxes.

💡 Key takeaway: Any money withdrawn from the business—whether a loan repayment or reimbursement—must be properly documented. Otherwise, it could be reclassified as wages, leading to additional taxes.

Final Thoughts

Reasonable compensation is not tied to profit or loss—it’s tied to distributions.

If an S Corp owner is taking money out of the business, the IRS expects wages to be paid first. Anything taken beyond that can be a distribution.

The rules around reasonable compensation can be complex, and missteps can lead to IRS penalties, reclassified wages, and unexpected payroll taxes. Having a proactive tax strategy in place is essential.

👉 If you need guidance on setting reasonable compensation, structuring distributions, or planning for tax efficiency, our team at Molen & Associates is here to help!

📅 Schedule a consultation today!

The Molen & Associates Difference

Mike Forsyth

“Super helpful and timely. This is our first year with them and we look forward to trusting them with our taxes and business books for years to come.”

Caitlin Daulong

“Molen & Associates is amazing! They run an incredibly streamlined process, which makes filing taxes a breeze. So impressed with their attention to detail, organization, and swift execution every year. Cannot recommend them enough!”

Sy Sahrai

“I’ve been with Mr. Molen’s company for few years and I felt treated like family respect and dignity. They are caring, professional and honest, which hard to find these days. Love working with them.”

In-Kind Donations: Understanding Their Impact on Taxes and How to Account for Them

In-Kind Donations: Understanding Their Impact on Taxes and How to Account for Them In-kind donations are a valuable way for individuals and businesses to contribute to charitable organizations. These non-cash contributions can take many forms, from donated goods and...

Tax Loss Harvesting: A Strategic Guide to Reducing Your Tax Bill

Tax Loss Harvesting: A Strategic Guide to Reducing Your Tax Bill Investing in the stock market comes with its share of ups and downs, but even losses can offer a silver lining through a strategy known as tax loss harvesting. This technique allows investors to turn...

How to Deduct Your Travel Expenses for Business

Maximizing Your Tax Savings While Traveling Traveling for business can be a great opportunity to mix work with leisure while benefiting from significant tax deductions—if done correctly. However, many small business owners overlook travel deductions, missing out on...

Almost the Last Chance to Claim the 2021 Employee Retention Credit (ERC)!

Time is running out for eligible businesses to claim the valuable Employee Retention Credit (ERC) for 2021. If your business hasn’t taken advantage of this substantial tax credit, there’s still a window of opportunity—but it’s closing fast. The deadline to amend your...

Understanding RMDs: What They Are and Why They Matter

Understanding Required Minimum Distributions (RMDs): What They Are and Why They Matter When planning for retirement, it's essential to understand the various rules and regulations that govern how you can access and manage your retirement savings. One of the most...

S Corp Owns Rental Property: What Happens If You Die?

What if you die and your S Corp owns rental property? Owning rental property through an S Corporation (S Corp) can offer various tax advantages and liability protection during your lifetime. However, the situation becomes more complicated when the owner of an S Corp...

Understanding EIN Numbers: Common Pitfalls & Everything You Need to Know

Understanding EIN Numbers: Common Pitfalls & Everything You Need to Know - EIN Filing & Business Success Success with Business Formation & EIN Filing: When starting a business, one of the first steps is obtaining an Employer Identification Number (EIN)....

How Can I Make the Most of my Tax Meeting?

Maximize Your Tax Advisor Meeting: A Comprehensive Checklist We meet with a lot of clients and complete a lot of tax returns during tax season, so time is very precious! We want to make the most of each minute we spend with you, so we have compiled a list of a few...

How to Determine Your Tax Withholding: A Comprehensive Guide

How to Determine Your Tax Withholding: A Comprehensive Guide Understanding how to properly set your tax withholding is crucial for managing your finances and avoiding surprises at tax time. Whether you’re an employee deciding much to withhold in each paycheck or a...

Tax Considerations for Non-Profit Organizations

Tax Considerations for Non-Profit Organizations: Understanding the Unique Tax Obligations and Benefits Non-profit organizations play a critical role in communities, offering services and programs that address societal needs while receiving tax benefits. However,...

Request an Appointment Today

3 + 1 =

Call us at

Pin It on Pinterest

Share This