The concept of “reasonable compensation” is particularly relevant for S corporations and other pass-through entities where shareholders are also employees. The IRS requires that these entities pay their shareholder-employees a “reasonable” salary for the services they provide, which is subject to employment taxes, before distributing any profits as dividends, which are not subject to these taxes. Here’s an in-depth look at IRS reasonable compensation:
What is Reasonable Compensation?
Reasonable compensation is the amount that would ordinarily be paid for like services by like enterprises under like circumstances. This concept is used to determine the appropriate salary for shareholder-employees of S corporations to ensure that they are not avoiding payroll taxes by taking most of their income as non-taxable dividends.
Why is it Important?
The IRS scrutinizes S corporations to ensure that they are not underpaying salaries to avoid payroll taxes. If the IRS determines that an S corporation has paid an unreasonably low salary, it may reclassify dividends as wages, resulting in additional taxes, penalties, and interest.
Factors Considered in Determining Reasonable Compensation
The IRS and courts consider several factors to determine what constitutes reasonable compensation:
- Role and Responsibilities: The nature of the employee’s role, including their duties and level of responsibility within the company.
- Time and Effort: The amount of time and effort the employee dedicates to the business.
- Training and Experience: The employee’s education, training, and years of experience.
- Dividends and Distributions: The amount of dividends and other distributions paid to the shareholder-employee.
- Industry Standards: Compensation levels for similar positions in the same industry and geographic area.
- Company Size and Financial Condition: The size of the company and its financial health, including revenue, profits, and growth.
- Comparability Data: Compensation data from similar companies and positions, often sourced from industry surveys and reports.
- Economic Conditions: Broader economic conditions that may affect compensation levels.
How to Determine Reasonable Compensation
To determine reasonable compensation, S corporations can take the following steps:
- Conduct a Compensation Study: Use industry surveys, compensation databases, and other resources to gather data on salaries for similar positions.
- Document the Process: Keep detailed records of the process used to determine the salary, including any comparability data and the rationale for the chosen salary amount.
- Consult Professionals: Work with accountants, tax advisors, and compensation consultants to ensure that the salary is reasonable and defensible.
- Regular Reviews: Periodically review and adjust salaries to reflect changes in the business, the employee’s role, and market conditions.
IRS Audits and Reasonable Compensation
If the IRS audits an S corporation and finds that the salary paid to a shareholder-employee is unreasonably low, it may:
- Reclassify Dividends as Wages: The IRS may reclassify dividends as wages, which would subject them to payroll taxes.
- Assess Additional Taxes and Penalties: The corporation and the shareholder-employee may be liable for additional employment taxes, penalties, and interest.
Case Law and IRS Guidance
Several court cases and IRS rulings have provided guidance on what constitutes reasonable compensation. Notable cases include:
- David E. Watson, P.C. v. United States (2002): The court upheld the IRS’s recharacterization of dividends as wages, emphasizing the importance of considering industry standards and the employee’s role.
- Revenue Ruling 74-44 (1974): The IRS provided factors to consider when determining reasonable compensation, which have been influential in subsequent cases and audits.
Best Practices
To minimize the risk of an IRS challenge, S corporations should:
- Pay a Reasonable Salary: Ensure that salaries paid to shareholder-employees are in line with industry standards and reflect the employee’s role and contributions.
- Maintain Detailed Records: Document the process used to determine salaries, including comparability data and any adjustments made over time.
- Seek Professional Advice: Consult with tax and compensation professionals to ensure compliance with IRS guidelines.
By understanding and applying the concept of reasonable compensation, S corporations can better manage their tax obligations and reduce the risk of IRS audits and penalties.
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