If you are the owner of an S Corporation, you need to be aware of a very prevalent Audit issue with the IRS. The issue is Reasonable Compensation taken by the S Corporation shareholder.
Reasonable compensation is defined by the IRS as “The value that would ordinarily be paid for like services by like enterprises under like circumstances.” or the hypothetical “Replacement Cost” of the shareholder-employee”
Here are some important points for the S Corporation owner to know.
- Reasonable Compensation is based on the value of services provided (Hypothetical Replacement Cost), not profit, distributions, or the amount the company can afford to pay.
- Wages (Reasonable Compensation) should be paid BEFORE distributions are made. No distribution can be taken if no reasonable compensation is paid.
- A shareholder-employee can take wages (Reasonable Compensation) without taking a distribution, but not vice versa. Reasonable Compensation is derived from the value of the services provided, not the profit or loss of the business.
- The IRS also has the authority to reclassify “distributions” made to an S corporation shareholder as payment for wages. I.R.C. §7436; Rev. Rul. 74-44, 1974-1 C.B. 287.
- The reclassification of wages can lead to large amounts of penalties and interest being due to the IRS.