What You Need to Know About S-Corps and Reasonable Compensation

As a business advisor, it’s essential to understand the complexities of structuring a business entity. Among the various options available, S Corporations (or S Corps) stand out for their tax advantages and flexibility. As the March deadline for the S Corp election draws near—March 15, 2024, to be exact—business owners may turn to you for advice on whether the S Corp is suitable for their business.

One crucial aspect that often confuses business owners and advisors is determining reasonable compensation for shareholders actively involved in the business. Here’s what to know about the popular S Corp tax election and how reasonable compensation keeps your clients on the Internal Revenue Service’s (IRS) good side.

What Is an S Corp?

According to the IRS, S Corps outnumber any other type of corporation in the United States^1. S Corps are especially popular for small to medium-sized businesses due to their pass-through taxation feature, which allows income and losses to flow directly to shareholders’ personal tax returns. Many companies structured as corporations file taxes as an S Corp to avoid the double taxation burden that comes with being a C Corporation.

In general, businesses structured and registered as a C Corp or Limited Liability Company (LLC) may file for the S Corp tax election in the current tax year if:

• The company is a U.S.-based corporation.
• All shareholders are U.S. citizens or resident aliens.
• The corporation has no more than 100 shareholders.
• The corporation has only one class of stock.
• All shareholders agree to the S Corp election by signing and submitting IRS Form 2553 by the S Corp deadline.

If a company fails to follow the above requirements, such as by having too many shareholders, the IRS will automatically revoke the corporation’s S Corp status and prohibit the company from S Corp reelection for five years.

Being an S Corp benefits corporations because the distinction allows the owners to save on payroll taxes by dividing business income into salaries and shareholder distributions. Owners, therefore, only need to pay payroll taxes on wages and not on shareholder distributions.

However, because business owners may divide salaries and distributions disproportionately, such as paying owner/employees too low of a salary, the IRS scrutinizes dividend distributions to ensure companies aren’t trying to avoid paying payroll taxes. That’s where the “reasonable compensation” concept comes into the equation.

The Importance of Reasonable Compensation

It’s a fine line for business owners to walk since one of the primary benefits of being an S Corp is the ability to distribute profits to shareholders as distributions rather than salaries, potentially reducing payroll taxes. However, as part of the election requirements, the IRS requires S Corp shareholders who work for the company in any capacity to receive “reasonable compensation.” Shareholders working for the company are considered shareholders/employees and must pay payroll taxes.

Factors Influencing Reasonable Compensation

Determining reasonable compensation is not a one-size-fits-all approach. Several factors come into play, including:

• Industry Standards: The nature of the business and prevailing industry standards significantly influence what constitutes reasonable compensation. Salaries for similar positions in comparable companies serve as benchmarks.
• Duties and Responsibilities: The level of involvement and responsibilities should align with the compensation received. Shareholders actively participating in daily operations, management, or key decision-making processes typically warrant higher compensation.
• Skills and Experience: The qualifications, expertise, and experience of shareholder-employees play a pivotal role in determining compensation. Highly skilled individuals with specialized knowledge may command higher salaries.
• Company Performance: The financial health and profitability of the business also impact reasonable compensation. A company experiencing growth and generating substantial profits may justify higher salaries for shareholder-employees.

Compliance with IRS Guidelines

Navigating the IRS guidelines regarding reasonable compensation is essential to avoid potential audits or penalties. While the IRS doesn’t provide specific formulas for calculating reasonable compensation, they expect shareholder-employees to receive a salary comparable to what they would earn for similar services in another business in the same industry.

You can help your clients document the process of determining reasonable compensation, including research on industry benchmarks, detailing the duties and responsibilities of shareholder-employees, and maintaining records of compensation decisions.

Mitigating Risks

Failing to pay reasonable compensation can trigger the IRS’s attention and potentially lead to costly penalties and back taxes. As a business advisor, you can educate your clients about the importance of adhering to IRS guidelines and implementing best practices for determining reasonable compensation.

Once your client elects S Corp status, conducting regular reviews to adjust shareholder-employee compensation based on changes in roles, responsibilities, and company performance is crucial. You can also help by staying updated on changes to tax laws and regulations about S Corps to ensure compliance.

By implementing best practices and providing professional guidance, your business clients can maximize the benefits of S Corp taxation.