Let’s talk about reasonable compensation. If your owner-employee clients skip the paycheck and pull all income as distributions, you may be playing with fire.
What the IRS Expects
Corporate officers are employees under federal employment tax law. So, if an owner-officer actively works in their business, they are expected to take a salary before distributions. That salary must be “reasonable compensation,” which is a formal way of saying: what would the corporation pay someone else to do that job?
Skipping this step and taking distributions instead of wages does not avoid taxes—it is an evasion of payroll tax obligations.
The Cases That Made the Point
In Watson, an accountant took a $24,000 salary while pocketing over $200,000 in distributions. The court sided with the IRS and reset his salary to $91,044, based on compensation data for accountants with similar responsibilities (Watson v. U.S., 668 F.3rd 1008 [8th Cir.]).
In McAlary, a real estate broker took no salary and $240,000 in distributions. The Tax Court didn’t love the IRS’s method, but they recharacterized $83,200 of the distributions as wages—using a conservative hourly rate of $40 based on the broker’s experience and workload (Sean McAlary Ltd. Inc. v. Comm., T.C. Summary Opinion 2013-62.).
The key takeaway? The IRS doesn’t need a corporation to be large, complex, or aggressive to take an interest. Just underpaying the shareholder while pulling large distributions is enough.
There’s No Formula—But There Are Expectations
Facts and circumstances determine reasonable compensation. In many instances, the courts have laid out several factors that assist in establishing what is “reasonable,” including:
- type and extent of the services rendered
- scarcity of qualified employees
- qualifications and prior earning capacity of the employee
- contributions of the employee to the business venture
- net earnings of the employer
- prevailing compensation paid to employees with comparable jobs and
- peculiar characteristics of the employer’s business.
While these factors above come from the Tax Court, the 7th Circuit stated on appeal that these factors did not provide “adequate guidance to a rational decision.” While these factors may be considered, other factors that push reasonable compensation to be higher or lower may come into play (Exacto Spring Corp. v. COMM., 84 AFTR 2d 99-6977 [196 F.3d 833]).
Some other factors considered by the IRS include:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
While there is no bright-line test, businesses with meaningful profits and little to no compensation to shareholders should expect scrutiny.
Why It Matters More Now
Historically, compensation hasn’t been a frequent target in field exams. But that’s changing. The IRS’s push towards utilizing AI makes it especially easy to find S corporations not paying reasonable compensation to shareholders. Many audits are opened on an S corporation for one reason or another, which then brings the amount of shareholder compensation under review.
And the risks go beyond back taxes and penalties:
- Reclassifying distributions as wages triggers retroactive payroll taxes (plus interest and penalties).
- It may reduce Social Security benefits if reported wages are too low.
- It reduces the §199A deduction—because qualified business income excludes wages improperly taken as distributions.
Acceptable Reasons for Low/No Compensation to Shareholders
We have seen many times under audit that a shareholder’s reasonable compensation may be little to nothing in the following instances:
- The shareholder took no distributions and used profits to reinvest into the S corporation. For example, the taxpayer started their business and made money in year one. They retained all the money within the S corporation, neither distributing nor lending it out and spent the funds the following year.
- The shareholder performs very few services to the corporation. For example, a dentist may own their clinic but provide no services to the entity other than occasionally showing up in the office to supervise the other dentists and administrators.
Note: In any of the above situations, the S corp should document the facts and circumstances in its corporate minutes. It is common for auditors to ask for such documentation in the course of a reasonable compensation audit.
Final Thought
There’s no IRS-blessed percentage of profits that can be used to calculate reasonable compensation. The principle is based on replacing shareholder labor, not slicing their bottom line.
If you or your clients are running S corporations, make reasonable compensation a routine part of year-end planning. Run comps, document your reasoning, and make sure payroll reflects reality. Don’t let the IRS determine the amount of reasonable compensation; being proactive and remaining in compliance will help prevent the IRS from stepping in to make that decision for you.
Learn more about reasonable compensation and other tax issues related to S corporations and business taxation in general at our upcoming Entity Essentials class.