What is reasonable compensation for s-corp owners?

What is reasonable compensation for s corp owners?

Section 162 of the tax code states, "a reasonable allowance for salaries or other compensation for personal services actually rendered," but what does this mean for your s-corp owner compensation?

The term you will hear repeatedly when it comes to S-corp owners and compensation is, "reasonable." The first thing that pops into most people's minds, is what on earth does reasonable mean for s-corp owner compensation?  Understandably, you may be confused.  Thankfully, the IRS provides guidance on this tax law, but it might still confuse you.

There are three parts to S-Corp owner compensation that you should pay close attention.  They are satisfying the IRS with reasonable compensation, how it affects your taxes, and your retirement plan contributions.

S-Corp Owners Reasonable Compensation Guidance

U.S. Tax Code Section 162 defines trade or business expenses, specifically, s-corp owners compensation.  The term that gets repeated is, "reasonable."  It's in the tax code and a major part of the IRS guidance on s-corp owners' compensation.

Internal Revenue Code Section 162 along with the IRS Rev. Rul. 99-7, allows a deduction of ordinary and necessary business expenses, including reasonable compensation. Sec. 162 defines reasonable compensation as the amount that would ordinarily be paid for like services by like organizations in like circumstances.

The definition is not as helpful as we would appreciate.  However, the IRS provides more guidance on its website and has a published job aid packet for IRS agents and we can also review existing case law.


IRS Guidance on S-Corp Owner's Compensation

The IRS has a full page dedicated to explaining how to pay yourself.  Unfortunately, you will likely be disappointed with their guidance.

The IRS simply states, "public libraries may have reference sources that provide averages of compensation paid for various types of services."

You can find the IRS, "Paying Yourself," at the bottom under, "reasonable compensation," here.

IRS Guidance for IRS Professionals

The Job Aid for IRS Valuation Professionals guide was published a while back but still appears relevant.  You can read up on their internal guidance on reasonable compensation but I did want to point out how this can go wrong.  In the background section, the IRS describes where the "reasonable compensation issue comes up when the amount of compensation paid may be lower than reasonable to avoid the payment of employment taxes."

Paying yourself less compensation means you are also paying less FICA taxes.  But it's not a one-way street either.  Think of the other side of paying yourself too much.  I'll exaggerate an example with someone earning $500,000 per year who works 1 hour per month on clerical work.  It could be construed as a gift and not necessarily compensation.


Existing Case Law

I'm not going to go into the case law, however, you can read up on it here. CPAJournal.com summed it up well with an excerpt from case law involving s-corp owners' compensation.

“Reasonableness of the compensation amount also presents a factual question to be resolved within the bounds of the individual case.” -CPAJournal.com

How S-corp Owner's Compensation affects Taxes

I have outlined this previously, but the owner's compensation is subject to FICA tax whereas distributions are not.  It's more or less that simple.

FICA tax is the social security and medicare taxes you pay on your compensation.  As a side note, retirement plan contributions are also subject to FICA.


How S-Corp Owner's Compensation affects Retirement Plan Contributions

Generally, when it comes to retirement plans, there are two types of contributions, elective and nonelective.  The elective contributions are what you contribute as an employee through a salary deferral.  If you have a 401k that's the $19,500 (2021 limit) or $20,500 (2022 limit) employee limits that you can contribute to your plan.  The nonelective is the profit-sharing contribution.  An S-corp owner can contribute up to 25% of their W-2 earnings.

Simply put, the more you are compensated the higher amount you may contribute to your retirement plan.