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.
How Much is reasonable?
As 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. The IRS has shot this down in courts. Furthermore, this is where the term reasonable compensation comes in.
Business owners that perform a substantial contribution to the business are required by the IRS to be paid a salary. This is called reasonable compensation. You can’t pay yourself below market and take a large amount in distributions.
furthermore, an IRS issued fact sheet describes the guidelines and principles 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 an issue or concern for your business, please feel free to reach out and let us know how we can help.