The reasonable compensation conundrum isn’t just some theoretical tax wrinkle. It has real-world implications that can affect how much you pay in taxes, how much scrutiny your business faces, and your ability to plan accurately for the future.
S corporations benefit from reduced payroll tax liability because distributions (profits) aren’t subject to Social Security and Medicare taxes. However, this benefit becomes a red flag when owner-employees pay themselves an unreasonably low salary to maximize their distributions. Underpaying yourself could land you in hot water with the IRS, resulting in significant penalties.
The words “IRS audit” alone can cause any business owner to break into a cold sweat. According to IRS guidelines, businesses that don’t comply with reasonable compensation rules raise audit flags. The penalties for noncompliance can include back taxes, interest, and potential fines—not exactly the financial hit any entrepreneur wants to face.
Establishing a clear, reasonable salary keeps your financial records clean and aligned with IRS expectations. It also makes it easier to plan for business investments, personal income, and long-term growth.
Now that we’ve established why reasonable compensation matters, you’re probably wondering, “How do I figure out what a reasonable salary looks like?” The good news is you don’t have to guess. Consider these steps to determine a fair compensation amount for yourself or other owner-employees in your business:
Your salary should reflect the work you do in the business. Are you the CEO juggling strategic planning and sales? Or do you only step in sporadically, acting as a part-time consultant? The level of responsibility and time commitment plays a big role in setting a fair salary.
Look up average salaries for roles similar to yours in comparable businesses within your industry. Websites like Glassdoor, Payscale, or government resources like the Bureau of Labor Statistics are great places to gather this data.
A reasonable salary should factor in the size and profitability of your business. A small startup might start with modest pay for its owner-employee, while an established organization with significant cash flow could afford a higher salary.
Location matters. The same position may command vastly different salaries in New York City compared to a smaller rural town. Adjust your expected compensation accordingly.
When in doubt, lean on experts. Accountants and financial advisors experienced in incorporation compensation can provide insights tailored to your business, ensuring compliance with IRS standards.
Navigating the reasonable compensation rule can be tricky, and unaware business owners often make avoidable errors. Here’s what to watch out for:
While it’s tempting to minimize your salary in favor of bigger distribution checks, the IRS views this as a red flag. Be realistic and make sure your salary aligns with your contributions.
When calculating reasonable compensation, don’t forget to include the value of perks like health insurance or retirement contributions. These elements contribute to the total salary package.
Your salary shouldn’t remain static forever. Revisit it annually or whenever your role, business revenue, or industry benchmarks change.
It’s essential to strike a balance. Overusing distributions for pay without a reasonable salary could trigger IRS scrutiny.
The reasonable compensation conundrum is one of many considerations when incorporating your business, but it’s one that requires careful planning. By setting a fair and transparent salary for yourself as an owner-employee, you’re not only staying compliant with IRS rules but also setting a strong financial foundation for your business.
At SD Mayer & Associates, we understand that incorporation compensation decisions can feel, well, overwhelming. Our team specializes in guiding small businesses and entrepreneurs through financial intricacies like these, offering custom strategies so you can focus on growing your enterprise.
Thinking about incorporating your business or navigating compensation challenges? Don’t go it alone. Our expert advisors are here to simplify the process and help you confidently tackle reasonable compensation rules. Schedule a consultation with SD Mayer & Associates today and take your business to the next level.