By: John S. Morlu II, CPA
When running a business, especially as a shareholder in an S corporation or C corporation, it’s crucial to understand the concept of reasonable compensation. The IRS is always on the lookout for business owners who underpay or overpay themselves to manipulate taxes. Striking the right balance can save your business money and help you avoid unnecessary IRS scrutiny.
Let’s explore what reasonable compensation is, why it matters, and how tax-saving strategies can be applied to shareholder-employees in S and C corporations.
What Is Reasonable Compensation?
Reasonable compensation refers to the amount of money a shareholder-employee is paid for the work they perform in their business. This amount must reflect the services rendered and should align with industry standards. The IRS requires reasonable compensation to ensure that salaries are neither too low (to avoid employment taxes) nor too high (to dodge corporate taxes).
Why It Matters:
- For S Corporations: The IRS focuses on ensuring shareholder-employees don’t underpay themselves to avoid paying Social Security and Medicare taxes.
- For C Corporations: The concern is often the opposite. The IRS wants to ensure that shareholder-employees aren’t overpaid as a way to disguise dividends (which are taxed twice: once at the corporate level and again at the individual level).
Tax Savings Tips for S Corporations
1. Set Compensation on the Low End (Legally):
While the IRS doesn’t require S corporation shareholders to take all business income as wages, the compensation must be reasonable. This means you can set your salary on the lower end of the spectrum as long as it is justified. Use salary guides, industry benchmarks, and job-specific data to support your decision. This minimizes payroll taxes while still satisfying the IRS.
2. Support Your Salary with Evidence:
- Document your job duties and time commitment to the business.
- Use reputable sources like the Bureau of Labor Statistics or trade associations to show that your compensation aligns with others in similar roles and industries.
- If challenged, presenting a clear and detailed rationale for your salary can protect your business from penalties.
Tax Savings Tips for C Corporations
1. Develop Bonus Formulas for Predictable Net Income:
For mature businesses with steady earnings, a pre-determined bonus formula in shareholder-employee contracts can help you maintain reasonable compensation while reducing taxable corporate income. For example, your contract could include a bonus that’s tied to company profitability. If designed carefully, this approach allows your company to break even or come close while staying within the IRS’s reasonable compensation guidelines.
2. Separate Dividends from Compensation:
If your company is generating significant profits, consider paying regular dividends in addition to a reasonable salary. Dividends are not tax-deductible to the corporation, but they help distinguish returns on investment from wages. This demonstrates to the IRS that you are not using excessive salaries to avoid taxes.
3. Adjust Salaries Based on Workload:
If your involvement in the business changes—for example, if you reduce your working hours or transition responsibilities to other team members—adjust your salary accordingly. Paying yourself a salary that doesn’t reflect your actual work could raise red flags.
Using Salary Guides and Market Data
Supporting your compensation decisions with data is one of the best ways to meet IRS requirements. Here are some useful resources:
- Bureau of Labor Statistics (BLS): Provides detailed compensation data by industry and job type.
- Industry-Specific Reports: Trade associations and consulting firms often publish salary benchmarks for various roles.
- Online Salary Tools: Subscription databases like PayScale or Glassdoor offer real-time salary insights.
Using these tools, you can build a solid case that your salary is both reasonable and competitive.
Bonus Formulas: A Powerful Tax Strategy for C Corporations
Pre-determined bonus formulas in shareholder-employee contracts are an effective strategy for maintaining compliance and managing taxes. Here’s how they work:
1. Link Bonuses to Performance: Tie bonuses to measurable factors such as net income, revenue growth, or operational efficiency. This ensures that bonuses align with business performance and don’t look like disguised dividends.
2. Set Predictable Bonus Structures: For companies with steady earnings, you can create a formula that ensures the business approximately breaks even each year. For example:
- 20% of profits after taxes are distributed as bonuses.
- Bonuses are capped at a certain percentage of annual revenue.
3. Document Everything: Clearly outline bonus structures in employment contracts and corporate policies. This transparency strengthens your case if the IRS reviews your compensation practices.
The Risks of Non-Compliance
Failing to set reasonable compensation can lead to significant consequences:
- For S Corporations: The IRS may reclassify some of your business income as wages, subjecting it to additional payroll taxes, interest, and penalties.
- For C Corporations: Excessive compensation may be reclassified as dividends, which are not tax-deductible. This could result in double taxation and additional penalties.
Summary: Best Practices for Reasonable Compensation
1. Document Your Decisions: Keep detailed records of how you determined compensation levels. Use market data, salary guides, and job descriptions to back up your claims.
2. Create Clear Policies: For C corporations, use bonus formulas that align with company performance. For S corporations, justify lower salaries with evidence of your role and responsibilities.
3. Pay Dividends: For C corporations, regular dividend payments demonstrate that your business distinguishes between wages and investment returns.
4. Adapt to Changes: Adjust compensation levels to reflect changes in workload, responsibilities, or business performance.
By understanding and implementing these strategies, you can optimize your tax savings while staying compliant with IRS regulations. Reasonable compensation isn’t just a requirement—it’s a smart way to manage your business finances effectively.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
• ReckSoft (www.ReckSoft.com): AI-driven reconciliation software revolutionizing financial accuracy and efficiency.
• FinovatePro (www.FinovatePro.com): Advanced cloud accounting solutions empowering businesses to thrive in the digital age.
• Fixaars (www.fixaars.com): A global handyman platform reshaping service delivery and setting new benchmarks in convenience and reliability.
Under his strategic vision, JS Morlu continues to set the gold standard for technological excellence, efficiency, and transformative solutions.
