S Corporation shareholders who provide substantial services to the business must have “reasonable compensation” or reasonable salary. Determining reasonable compensation can be difficult for a lot of shareholders. While some shareholders rely on the 50/50 rule for salary and distributions this is not an Internal Revenue Service (IRS) accepted method for determining reasonable compensation. The IRS is aware of S Corporation shareholder’s motivation to maximize dividends or distributions and minimize payroll to avoid self-employment taxes. As a result, S Corporation tax return audits are on the rise. Of the returns audited in 2007-2011, each resulted in an average of over $100,000 in adjustment recommendations so there is a significant under payment issue on payroll for S Corporation shareholders.
What is reasonable compensation?
· Replacement Cost – What you would pay someone else to do your job
· Fair Market Value – What someone would pay you for your job (hourly rate x 2,080 hours of work)
In August 2008, the IRS released a fact sheet (FS 2008-25) to help provide some guidance on determining reasonable compensation. They stated that when assessing reasonable compensation they use 9 main factors:
1. Training and Experience (Degrees held by officer and length of time in industry)
2. Duties and Responsibilities
3. Time and Effort Devoted to the Business (Capped at 2,080 hours per year)
4. Dividend (Distribution) History
5. Payments to Non-Shareholder Employees (Other employees receiving more compensation than main shareholder)
6. Compensation Agreements (Whether these are added to Corporate minutes)
7. Timing and Manner of Paying Bonuses to Key People
8. What Comparable Businesses Pay for Similar Services
9. Whether a Formula was Used to Determine Compensation
The key takeaway is that reasonable compensation is not a simple calculation. S Corporations need to document how they are determining reasonable compensation for S Corporation shareholders who provide substantial services to the business.