Reasonable compensation: Is your S corp paying you enough?

Entrepreneurs often struggle with the question of how much to pay themselves. The underlying rule is that individuals who own and operate their business through an S corp need to pay themselves a “reasonable” salary. This rule also applies to any family members hired to help with the business, such as a spouse, parent, child, and even your grandchildren.

S corp shareholders are often tempted to pay themselves less because salaries are subject not only to federal and state income tax, but also to Social Security and Medicare taxes, federal and state unemployment insurance, and other various state and local payroll taxes. However, S corp profits passed through to the shareholder are not subject to these extra payroll taxes.

The IRS is aware of the tendency for S corp shareholders to underpay certain employees, and sometimes raises this issue when auditing closely held businesses. If the IRS determines that a shareholder’s salary is unreasonably low, the S corp may be on the hook for unpaid payroll taxes. To limit this risk, S corp shareholders should be proactive in documenting that their salaries meet the “reasonable” salary requirement.

Here’s a quick way to tell if your salary is reasonable. Suppose you sold your S corp to an outside investor, and the new owner hired you to continue running the business. How much would this outside investor be willing to pay you for the work you do? In other words, a reasonable salary is an amount that similar businesses, under similar circumstances, would pay you for the same services. To document this, S corp shareholders should record their decisions regarding shareholder compensation in the corporate meeting minutes. And they should mention the factors that went into deciding the salary amounts for each shareholder. For example, shareholders should make note of the current financial condition of the S corp, how many hours the shareholder works, and the type of work that the shareholder performs.

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