What is reasonable compensation for s-corp owners?

Last Updated May 2, 2022//Travis Sickle, CFP®, EA®

Originally Posted Apr 12, 2022//Travis Sickle, CFP®, EA®

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.

Full Video Transcript: What is reasonable compensation for s corp owners?

Full Video Transcript

So you have an S-Corp and you're trying to figure out how much you should pay yourself. So in this video, I'm going to talk about how much you should pay yourself as reasonable compensation. I'm also going to talk about how you can reduce your taxes and how you can make sure that you're maximizing your retirement plan. Because your compensation is going to affect your retirement plan.

00:00:24:19 - 00:00:43:12
And we're going to do it by going through a couple of blogs, the tax law, and a couple of resources to help you figure this out. So let's get right into this, and we're going to start from the beginning and go over the tax law so you can understand where this is all coming from. So this website right here is meeting and more.

00:00:43:12 - 00:01:16:07
And I've never been to this website before, but they did give a good explanation of Section 162, which is the tax code that we need to focus in on for reasonable compensation of an S-Corp. So the Internal Revenue Code, Section 162 allows for allows the deduction of ordinary and necessary business expenses, including reasonable compensation. Section 162 defines reasonable compensation as the amount that would ordinarily be paid for like services by like organizations in like circumstances.

00:01:16:15 - 00:01:36:05
So already we can see that this is ambiguous and there's the word reasonable. What is reasonable? It's again, it's going to feel you're going to hear this throughout this video. Reasonable it is arbitrary. Feels arbitrary. And hopefully, we can get off arbitrarily because we don't want to have an arbitrary compensation. We need to be able to articulate it.

00:01:36:16 - 00:02:14:22
So let's go ahead and take a look at the tax code. And this is the tax code. US code 162 trade or business expenses. If you're wondering in a poll this length in the description at the bottom and right here, it says in general, there should be allowed as a deduction all the ordinary and necessary keywords. They're ordinary and necessary expenses, including compensation, paid or incurred during the taxable year in carrying on any trade or business, including one a reasonable allowance for salaries and other compensation for personal services actually rendered.

00:02:15:02 - 00:02:50:12
So that's the tax law. That's what we need to focus in on actually render. And we hear it again, reasonable. It's going to happen over and over with reasonable compensation. So let's go ahead and flip over to this other one last blog before we get on to the IRS website and more guidance on it. But they're actually referring to Section 162 and they give a similar definition, but they're pointing out the first resource that I want to go, go, go over with you so you can start to understand what is reasonable compensation and it's not their definition of section 162 that's highlighted up here.

00:02:50:22 - 00:03:12:26
It's over here. The guidance comes in from the IRS for the job aid Okay. So the guidance I totally misread that. The guidance comes in the form of a job for IRS valuation analysts. Okay. Let's bring up the job aid. So I went and found that I actually found the job before I found this particular website, but they're referencing it.

00:03:13:05 - 00:03:34:24
So let's jump over to it. So reasonable compensation The job aid for IRS valuation professionals. Now this is dated October 29th. 2014. I couldn't find an updated one but it does go over what reasonable compensation is. And it also offers us some insight as to the reason why it's important to understand and this is going to also tie in some taxation here.

00:03:34:28 - 00:04:10:15
Okay. So the background this is where I want to want you to focus in on the reasonable compensation. Again, the word reasonable issue usually involves a determination of whether the amount of compensation paid is reasonable so that it is deductible under Section one. 62 of the Internal Revenue Code for Income Tax purposes. In some cases, the reasonable compensation issue comes up when the amount of compensation paid may be lower than the reasonable but then reasonable to avoid the payment for employment taxes.

00:04:10:27 - 00:04:34:07
So that's what it's coming down to. So if you have an S-Corp, you have two ways that you're basically getting compensated. One is through your W-2. So that's actually paying you a reasonable wage. And the other is through distributions. No distributions, avoid self-employment tax. And I've talked a lot about this on this channel. It avoids it. So does that mean you should have all distributions?

00:04:34:07 - 00:04:57:11
Clearly, not. You need to have reasonable compensation. So your reasonable compensation is not just for tax purposes. It's also going to be for retirement planning because the amount that you can put towards your retirement plan, whether as is as an employee or the employer for the corporation, is going to be based on your W-2 So we have a twofold problem here.

00:04:57:12 - 00:05:19:11
First, we want to reduce our taxes and we want to pay the least amount in this case. The distributions will be federally taxable as well as your W-2, but only your W-2 is going to be subject to your self-employment taxes, your FICO. So that's what we want to focus in on. You want to pay yourself a reasonable wage, but enough so we can put more money towards our retirement plan.

00:05:19:11 - 00:05:39:06
So we have a lot of moving parts here. So there's not going to be one right answer for every situation. It really does depend on your particular situation, but the IRS does provide us with additional guidance. So if we go over to here, we can see this first notice that I found and it is just outlining exactly what I just talked about.

00:05:39:17 - 00:06:01:22
It says corporate officers are specifically included within the definition of employee for filing of Federal Insurance Contributions Act and future federal unemployment. So the Vika is your self is your your your taxes. So that's your Social Security and your Medicare on both sides. So that's what we want to take a look at there. And federal income tax withholdings under the Internal Revenue Code.

00:06:02:03 - 00:06:30:00
And this is here, subchapter SE corporations should treat payments for services to officers as wages and not distributions of cash and property or loans to shareholders. So you can get distributions, but what they're saying is it's not going to count towards reasonable compensation, only your actual compensation is. So that's what they're looking at. They're understanding, they're completely aware that people do not want to pay taxes so they can do everything in their power to reduce their taxes.

00:06:30:09 - 00:06:51:02
But if you reduce your W-2, you're reducing your self-employment less goes into Social Security. Arguably not a bad, bad thing to occur if you run those numbers, but you need to pay yourself a reasonable salary. But what it will affect is the amount that you can put into your retirement plan, because like I just said, it's affected by your W-2, not your distributions or things like your net profit.

00:06:51:09 - 00:07:13:27
That's not going to affect your retirement plan, only the W-2 side. Well, so let's go ahead and take a look at the IRS's website. Now, and this is paying yourself. So if we just scroll straight down on this on this site right here and reasonable compensation, again, there's the word reasonable, completely ambiguous.

00:07:14:04 - 00:07:45:24
But that's tax law. That's not the IRS. I just want to offer some clarity on that. You know, the IRS didn't write that law they just execute it. So because an officer of a corporation is generally an employee with wages subject to withholding, holding, corporate officers may question what is considerable, considered reasonable compensation for the efforts that they contribute to conducting their trade or business wages paid to you as an officer of a corporation should generally be commensurate with your duties.

00:07:46:02 - 00:08:10:27
Referred to employees' pay tests for deducting pay included in publication five 35 business expenses. For more information now, here it is here. Just focus on this. This is going to be even more arbitrary or feels more arbitrary. Public libraries may have reference sources that provide averages of compensation paid for various types of services. So there you have it.

00:08:11:05 - 00:08:38:02
It is it is very arbitrary, but you need to back it up. So you have to look at other people or in your industry, you have to look at how much you're working and you have to come up with something reasonable. So we started with reasonable. We're kind of going to end with reasonable. But there is some case law out there that I saw on the CPA Journal Econ, and it just goes over some case law that is talking about reasonable amounts.

00:08:38:14 - 00:08:53:18
And the case law and this is not where you really want to end up. You know you don't want to push the button because then the IRS will come after you and you have to defend yourself and you're going to go down a rabbit hole that is going to be costly just to get through.

00:08:54:07 - 00:09:26:20
So that's why you want to make sure that you want to pay yourself a reasonable salary, reasonable reasonableness of the compensation amount also presents a factual question to be resolved within the bounds of the individual case. And that's what it's describing right here. What that means is it really depends on your set of circumstances. So even if somebody in the same industry, in the same position is paid differently than you doesn't mean they're right and you're wrong or you're wrong and they're right, it's on your particular set of circumstances.

00:09:26:20 - 00:09:47:27
So the real guidance that the IRS provides is a document documenting all this stuff so that you can actually articulate why you're being paid, what you're being paid. So if you're asking a question, how much should I pay myself? It's really hard to tell you exactly how much you should pay yourself because only you are really going to know because you're the S-Corp owner and you're the one employing yourself.

00:09:47:27 - 00:10:09:04
So you need to figure that out. And this is how you can do it. You have to look at other positions that are similar to yours, how many hours you're putting in, and what services are rendered. And look at the sum of all of the parts. But you can see how it can be abused by putting more money over to the distributions instead of to your W-2 to reduce your federal taxes.

00:10:09:04 - 00:10:25:11
So hopefully this is giving you a little bit more guidance. I just kind of wanted to put this together really quickly with the S-Corp and how much you should pay yourself if you have questions on this or something I missed or something you have a question about, let me know in the comments down below. If you've enjoyed this video, be sure to subscribe and we'll see you on the next one.

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.