Reasonable Compensation, and the Case You Would Have to Make

Why it is contested

In an S corporation, amounts paid to an owner-employee as wages carry employment taxes. Amounts distributed as profit generally do not. The owner therefore has an obvious incentive to characterize as little as possible as wages, and the Service has an equally obvious interest in the opposite.

The standard is that compensation must be reasonable for the services actually performed. There is no statutory percentage, no safe harbor, and no formula that protects you. It is a facts-and-circumstances determination, which means it is an argument.

What the argument turns on

The factors that appear repeatedly in examinations and in the case law:

• The duties actually performed, and how much of the enterprise's output depends on the owner personally
• Time and effort devoted to the business
• Training, experience, and qualifications
• What comparable businesses pay for comparable services
• The company's history of distributions relative to wages
• Whether other employees are paid in a way consistent with the owner's stated role
• The company's size, complexity, and economic conditions

The documentation nobody has

Almost every owner we meet has a number. Almost none has a file explaining how it was reached.

A defensible position generally includes a description of the role as actually performed, comparable compensation data from a recognized source, an explanation of how the figure was derived, and evidence that it was revisited as the business changed. Prepared at the time. A memo written after a notice arrives is worth far less than the same analysis prepared when the decision was made.

The other direction

It is worth noting that too high is also a position, and it is one owners fall into by inertia. Wages above what the role warrants generate employment tax that was avoidable, and for owners approaching a transaction or running retirement plan contributions the interaction is worth modeling rather than assuming.

Where this lands

1. 01Write down what you actually do. Most owners underestimate the breadth and cannot describe it when asked under pressure.
2. 02Obtain comparable data from a real source rather than an impression of what peers pay.
3. 03Document the derivation this year, contemporaneously, and keep it.
4. 04Revisit annually. A figure that was defensible three years ago may not be after the business doubled.
5. 05Model the interaction with retirement contributions and any anticipated transaction, because the right number is not only an employment tax question.