What is Reasonable Compensation for S-corp Shareholders?

We’ve talked about compensation for S-Corp Owners before and there’s always more to think about on this complex topic.

A recent court case sided with the IRS in assessing payroll taxes plus penalties on imputed wages not taken by officers. This is a warning sign to some taxpayers that may have been tempted to avoid payroll taxes by taking a lower amount for salary and increasing their (payroll tax-free) distributions. The highlights: 

  • Wage was imputed at 120% of the FICA wage limit

  • Management fees paid to a related entity do NOT satisfy the reasonable compensation requirement.

Unfortunately there is no perfect formula for how to come up with your wages. As you can see from this court case, the IRS used the FICA wage limit as the rule of thumb for determining what the shareholder’s compensation should be (for 2021, this amount is $142,800). However, a reasonable wage amount can be determined using facts and circumstances. Some things to consider: 

  •  What would you pay someone to do the “job” you perform in your business (e.g. a highly qualified manager).

  • If you are a freelancer, what were you making at your previous job (adjusted for inflation)?

  • Review job postings on Indeed or LinkedIn and save documentation to support your conclusion.

Other things to consider are that lowering your payroll tax load should not be your only goal. You need to look at your tax picture as a whole to determine the balance between wages and distributions. There are some tax deductions that are based on the amount of salary that you take - these can result in a higher benefit on your tax picture than just the short-sighted view of your payroll taxes. For example: 

  •  Reduced SS benefits for shareholder/(maybe spouse)

  •  Reduced ability to fund qualified plan

  •  Potential QBI harm due to lower W-2

  •  Audit exposure (resulting in higher professional fees to defend).

We can help you navigate through these different decision points! If you don’t already have tax planning included in your current package, reach out to your client service manager or cpa@sherwoodtax.com to see how we can help.

Breakaway Advising