Reasonable Compensation

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.

1. 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.
2. Wages (Reasonable Compensation) should be paid BEFORE distributions are made. No distribution can be taken if no reasonable compensation is paid.
3. 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.
4. 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. 
5. The reclassification of wages can lead to large amounts of penalties and interest being due to the IRS.

The audit issue with the IRS is that many S Corporation owners either aren’t taking any reasonable compensation or not enough reasonable compensation.

We can generate a report based on the above listed items, combined with your current demographics, to will produce a report that will provide a reasonable compensation figure personalized to you.

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If you have questions about reasonable compensation or need help with the logistics of getting into compliance, as well as how much reasonable compensation an S Corporation owner should be taking, The Morrow Group can provide very specific guidance on this topic.