Entity Selection Part 3: S-Corporation Reasonable Compensation

By Steven Simonetti On August 22, 2023
Steven is a CPA & Manager at BSB.

We continue our Tax Talk Tuesdays entity selection series diving into reasonable compensation for S-corporation shareholders. This will be one of the IRS’ main areas of focus this year, and for good reason; it is easy money for them. As we mentioned in our last post, S-corporation owners have the unique ability to potentially save themselves thousands of dollars in employment taxes by virtue of how they compensate themselves, which is partly through W-2 wages and the remainder as profit distributions, which are not subject to employment taxes.

This mix of earnings is an area of potential significant tax savings, and it is a perfectly valid form of tax planning that every S-corporation owner should fully maximize. A logical conclusion would be to have the S-corporation distribute all of the profits as distributions and pay the owner a nominal salary or no salary at all. While great in theory, unfortunately the IRS is keenly aware of this and will shoot it down with ease.

The IRS does not frown on all distributions, just those that are taken before reasonable compensation is met. The goal of an IRS audit around reasonable compensation is to reclassify as much of the distribution to compensation as possible. This allows for the collection of the employment taxes originally avoided plus penalties and interest. It is estimated that the final cost is 2.5 times what the original tax would have been.

What is reasonable?

Reasonable compensation 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).

There are mythical rules that some believe help avoid IRS scrutiny or unfavorable adjustments upon audit. The most popular are the “50/50” or “60/40” Rule – which falsely claims that as long as compensation and distributions are equal or in a ratio of 60:40 then the IRS will not audit you or will accept this mix upon auditing your company. The truth is that reasonable compensation is more complicated and there is no standard formula. It essentially boils down to this single question: If the owner stopped working, what would it cost to hire someone to perform those same job responsibilities?

Reasonable compensation can be impacted by many factors:

  • Training/education and previous experience
  • Your duties and responsibilities in running the business
  • Distribution history
  • The time you devote to the business
  • Payments to non-shareholder employees
  • What similar businesses pay for similar roles

Where can I find resources to determine if my wages are reasonable?

  • The U.S. Department of Labor’s Bureau of Labor Statistics provides detailed wage data for more than 800 occupations broken down by location (e.g., state, metropolitan area, nonmetropolitan area, etc.) and is a good source for providing this documentation.
  • You can also refer to benchmark data on salary.com, indeed.com, etc. to get an idea of the going rate for a similar position in your geographic area.
  • Your accountant can perform benchmark studies to ensure your compensation is reasonable.

How the business structure plays into this, illustrated:

Another way that reasonable compensation should be looked at is how the business generates its revenues. If the business is primarily driven by the services of the shareholder, as in this case of professional services firms like doctors, dentists, consultants, etc. then most of the profit should be classified as wages. However, if the business is primarily driven by either capital (e.g., equipment) or non-shareholder services, as in the case of businesses like restaurants, retailers, manufacturers, etc., then it would be more reasonable to have a larger share of profit be treated as distributions.

It is important to understand that your business may not fit squarely into one of these categories, which is why it is such a fact and circumstances-based analysis that must be made.

Below is an illustration of a dental practice with a dentist as the sole shareholder. The practice may have administrative assistants and dental hygienists that generate revenue, however the dentist is largely responsible for the majority of the revenue that comes into the business, and dentists are highly compensated. The median salary for a dentist in Long Island is around $195 to $240k.

The dentist cannot decide to only pay himself $60k in order to save that $12k in taxes per year. The IRS will come knocking and this could cost him significantly more upon audit (upwards of $30k!), in addition to professional fees and time dealing with an audit, and the risk of opening up other areas of the financials to further IRS scrutiny.

Compare the dental practice in the previous illustration, for example, to a restaurant with a sole shareholder who manages the operations. While critical to the success of the restaurant, the majority of the revenue comes from the owner’s invested capital (in this case the mark-up of food and liquor) and non-shareholder employees (kitchen crew, wait staff, bartenders, etc.). The median salary for a restaurant manager in Long Island is around $58 to $72k. In this case, compensating the shareholder with a wage of $60,000 is significantly more likely to be deemed reasonable upon audit.

This is an example of how two different businesses with the similar level of profit could result in two wildly different conclusions on what is a reasonable mix of wage vs. distribution.

In summary, operating as an S-Corp can provide significant tax savings when planned properly. If you are a local business owner in New York and are unsure of whether you are maximizing your tax strategies or might be exposing yourself to unnecessary risk, feel free to request a consultation and we would be glad to discuss your situation further.

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