S-Corps and The Reasonable Compensation Dilemma

If you're reading this blog, chances are you're either considering forming an S-Corp or you have an S-Corp and are trying to determine the amount of salary you need to receive from the S-Corp. If you haven't decided yet, check out our blog about S-Corp Tax Savings.  So, how do you figure out what your salary (referred to as reasonable compensation for tax purposes) should be? The answer...it's complicated. There is no exact formula for figuring out what your reasonable compensation should be, instead you need to analyze all the facts of your specific situation to make the determination. And as you may have guessed, your analysis needs to be "reasonable."

WHAT REASONABLE COMPENSATION IS NOT...

To clear things up...let's start with an example:

A plumbing business taxed as an S-Corp grosses $250,000 and after deducting all business related expenses is left with net income of $150,000. The sole owner and employee of the S-Corp works full-time for the business and decides that they will pay themselves $20,000 as reasonable compensation and pass the other $130,000 through to themselves as a distribution.

 

Why would anyone ever try to do this? Well, in this scenario the owner/sole-employee of the business is still having to pay income tax on the full $150,000 but, they would avoid paying payroll taxes (FICA tax) on the $130,000 distribution.

FICA taxes

You see, this is where the tax savings can be realized as an S-Corp but, you also have to be sure that you're reasonable compensation is, well, reasonable. By setting your salary too low and avoiding the payroll taxes you could end up in hot water if it is deemed that this was done intentionally.

 

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HOW TO DETERMINE YOUR REASONABLE COMPENSATION

Let's break down the above example to see what steps could have been taken to arrive at reasonable compensation.

  1. How many hours did the owner/sole-employee of the business work?
    1. We know he works full-time for the business (40 hrs. a week or more) and at the federal minimum wage ($7.25 as of 2018) this would mean anyone working 40 hrs. a week would have a gross income of roughly $15,000-$16,000.
    2. In certain states the minimum wage is even higher. California for example has a state minimum wage of $11/hr as of 2018. This would mean a person working 40 hrs per week would have a gross income of roughly $23,000. So, right out of the gate you would be missing the mark for reasonable compensation because you'd be paying yourself less than minimum wage.
  2. What are the industry standards for a plumber's income?
    1. Looking at sites like Indeed.com we can see the average hourly income for a plumber in the U.S. is $22.49/hr as of writing this post. This means the average gross income for a plumber in the U.S. would be $46,000-$47,000.
    2. You can even narrow your search to include a state or city. The average hourly pay for a plumber in CA is $25.63 and in San Diego, CA it is $26.85.
    3. Other places that offer similar comparisons are Glassdoor.com, The Bureau of Labor Statistics, and Payscale.com. By using these sites you can get a better sense of what the industry standard for reasonable compensation may be.
  3. What did you report as net income for your business last year and pay yourself in previous years?
    1. If in previous years the net businesses income was significantly lower, it may make sense why the reasonable compensation was set so low.
      1. However, the argument could be made that the reasonable compensation should have been adjusted as the increase in net income was realized by the business.

Let's take a further look into this last example because perhaps there isn't a need to adjust your reasonable compensation.

S-Corp distribution calculation

 

WHY YOU WOULDN'T TAKE A DISTRIBUTION

Let's continue to use the example above to look at why you may actually have reason to only pay yourself $20,000 of reasonable compensation even though the net income of the business was $150,000.

  1. The business has debts that need to be paid or the potential for future debts.
    1. Business debts are not used in arriving at net income (other than possible interest that was paid). So, perhaps the reason for such a low reasonable compensation is the money left over can be used to pay down the debt of the business.
    2. The business may want to keep a certain amount of money in the coffers to cover future creditors (i.e. a lawsuit or judgement). This is also helpful from a "veil piercing" perspective because it prevents under capitalization (which is one of the major reasons shareholders of small corporations lose limited liability protection).

These reasons for not taking a distribution and keeping a low reasonable compensation are valid only if you in fact have legitimate reasons for doing so. If you were to pay yourself reasonable compensation of $20,000, then take a distribution of another $20,000 and claim the remaining $110,000 is there to pay for business debts or potential creditors, the IRS can come and say that the $20,000 labeled as a distribution will be reclassified as reasonable compensation due to the fact that you did not meet the "standard" reasonable compensation level for someone in your industry.

In other words, if you're going to try and do something like this, you need to make sure you are going to hit the reasonable compensation amount for the year before taking any distributions.

To add an additional wrinkle to this let's look at a few extra examples.

 

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TAKING A YEARLY OR MONTHLY APPROACH

When you are determining how to pay yourself reasonable compensation and when to take a distribution it comes down to timing and having a sense of what your income will look like for the year. Sometimes looking at previous years can be a good indicator but for certain professions like realtors, the income can be sporadic. So, let's take a look at two different ways to approach reasonable compensation and distributions.

Example 1:

You take a yearly approach to paying yourself reasonable compensation. This approach may be more helpful for those that cannot estimate what their business net income will be for the year. So, any net income realized from the business in the early part of the year would be paid to you as reasonable compensation. This continues throughout the year until you have hit the mark for reasonable compensation. Once this has been done, any net income from that point forward can be distributed to you or left in the coffers.
Reasonable Compensation and Distributions

Example 2:

You take a monthly approach to paying yourself reasonable compensation. This may be better suited for those that have a good understanding of what their business net income looks like on a year to year basis. If you can confidently say that you will receive a certain amount of net income each month, then dividing this up into reasonable compensation and a distribution is certainly doable. For instance, if you know you net $10,000 every month and your reasonable compensation that needs to be paid to you by the end of the year is $60,000, you can divide the $10,000 of net income into $5,000 of reasonable compensation each month and distribute the remaining $5,000 each month to yourself or keep it in the coffers. As long as you reach the reasonable compensation amount, which you should ($5,000 x 12 months= $60,000), taking distributions each month should not be an issue.

 

Remember, it really is all about reaching that reasonable compensation mark by the end of the year. If you don't and the IRS ends up taking a closer look at your returns, some or all of the distributions (depending on how much is needed to reach the reasonable compensation mark) made to you could be reclassified as reasonable compensation, which means you would then be liable for the payroll taxes on whatever was reclassified (plus penalties and interest).

WHAT IF YOU HAVE EMPLOYEES OTHER THAN YOURSELF?

Moving away from the examples above, let's take a look at reasons why your reasonable compensation could be more or less based on whether or not you have employees.

  1. How do your employees' pay and credentials compare to your own?
    1. If you have employees who are less qualified than you, work as many or fewer hours than you do, and you're paying them more than you're paying yourself in reasonable compensation, you may have a problem.
      1. The IRS will see this as a red flag because you are clearly more qualified (meaning you would generally be paid more) and work more hours than your employees. So, it wouldn't make sense that you as an employee of the business make less than they do. Don't forget, although you are the owner, you are also an employee of the business and need to sometimes look at the business from the employee perspective.

reasonable compensation

  1. How often are you working compared to your employees?
    1. If your time spent participating in the business is minimal, your reasonable compensation should reflect that. If you're not actively participating in the business at all, then there wouldn't be a need for paying yourself reasonable compensation.
      1. A good way to think of this is if one of your other employees was only working minimal hours you would only pay them for the time that they actually worked.

CONCLUSION

There is no set formula for figuring out what you should be paying yourself in reasonable compensation but, there are ways to make sure you do your due diligence when determining what your reasonable compensation will be.

  • Generally, you'll want to set your reasonable compensation inline with what the industry standards are for someone in your profession.
  • If you have employees, figure out how their credentials and time spent working for the business compare to your own. If you work less hours or none at all, it could mean that a lower reasonable compensation is valid.
  • Finally, having a legitimate reason for keeping your reasonable compensation low for the purposes of paying off business debts or making sure the business itself has reserves to pay for creditors is valid.

If you don't feel comfortable making a decision on your own or need to consult someone, do it. It's always better to ask the question and find the correct answer rather than just making a decision, moving forward, and finding out later you were wrong. You'll save yourself time and money in the long run.

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