S Corporations: A Brief Overview of Reasonable Compensation (RC) and IRS Implications

When it comes to reasonable compensation, documentation is a key factor in mitigating IRS penalty risks for S Corporations. For example, all salary information for any shareholder-employee should be clearly stated. To that end, the IRS looks at substantial services provided (job functions, time involved in the job functions, and industry comparisons) when determining reasonable compensation. (If a shareholder-employee does not provide substantial services, make sure to document the shareholder-employee as an officer in name only.) Also keep in mind that any loan made by an owner-officer to an owner-officer, including to self, must be documented as a loan (i.e. repayment schedule, interest, collateral). Otherwise, the IRS has the right to and may reclassify the transaction as compensation.   

It is not enough, however, to document names and salary figures. It is in your best interest to show calculations for how you came up with those figures - the IRS looks at the industry comparisons as a reference point. Corporate meeting minutes are an excellent place to reflect these calculations as well as pertinent information for reasonable compensation values.

There are two useful best practices for determining the value of RC: fair market value and replacement cost. Think of fair market value as what comparable businesses pay for similar services or value that would ordinarily be paid for like services by like enterprises under like circumstances. And, think of replacement cost as how much you could expect to pay per hour to another individual for the services performed. Keep these in mind while you calculate your RC. Although not an exact science, the IRS looks more favorably on well-researched and well-documented data.

To summarize – research, document, and be mindful that the IRS has the right to reclassify wages and distributions.

Listed below are some IRS red flags:

· $0.00 reasonable compensation and large distribution (could also result in loss of future social security benefits)

· Low salary vs. distribution paid

· Compensation paid only in Q4

· Out-of-line ratios – i.e. sales vs. comp, distribution vs. comp, and/or profit vs. comp

Reasonable compensation is a deep subject with many layers and possible consequences. For more information, please call the office of Ronald Castor LC at 913.469.9113.