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What is "Reasonable Compensation"?

What is Reasonable Compenasation to the IRS?Reasonable Compensation is a current high priority issue for the IRS concerning all corporations, especially S corporations

Wage Compensation for Corporation Officers

Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contribution Tax Act), FUTA (Federal Unemployment Tax Act), and federal income tax withholding under the Internal Revenue Code. When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages. Sub-chapter S corporations should treat payments for services to officers as wages, and not as distributions of cash and property or loans to shareholder or limited liability company members.

S Corporations are corporations that elect to pass corporate income, losses, deductions and credits through to their shareholders or LLC members for federal tax purposes. Shareholders or LLC members of S corporations report the flow-through income and losses on their personal tax returns, and are assessed taxes at their individual income tax rates.

The Internal Revenue Code establishes that any officer (member-manager) of a corporation, including S corporations, is an employee of that corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers (member-managers) treat their compensation as cash distributions, and/or loans rather than as wages.

Who’s an Employee of the Corporation?

Generally, an officer (member-manager) of a corporation is an employee of the corporation. The fact that an officer/Member-manager is also a shareholder/member does not change the requirement that payments to the corporate officer or member-manager be treated as wages. Courts have consistently held that S corporation officer/shareholder or member/manager who provides more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes.

The Treasury Regulations provide an exception for an officer/shareholder or member/manager of a corporation who does not perform any services or performs only minor services, and who neither receives nor is entitled to receive, directly or indirectly, and remuneration. Such an officer/shareholder or member/manager would not be considered an employee.

What is Reasonable Salary?

The instructions to the Form 1120 S, US Income Tax Return for an S Corporation, state, “Distributions and other payments by an S corporation to an S Corporate Officer/shareholder or member/manager must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”

The amount of the compensation will never exceed the amount received by the Officer/shareholder or manager/member either directly or indirectly. However, if cash or property, or the right to receive cash or property, did go to the Officer/shareholder or manager/member, a salary amount must be determined, and the level of salary must be reasonable and appropriate.

There are no specific guidelines for reasonable compensation in the Code or Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

Some Factors Considered by the Courts in Determining Reasonable Compensation:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history of the corporation
  • Payments to non-shareholder/members employees
  • Timing and manner of paying bonuses to key employees
  • What comparable businesses pay for similar services
  • The use of a formula to determine compensation
  • Amounts of taxable fringe benefits received by the officer/shareholder or manager/member
  • Prior year compensation in relation to corporate incomes