What is Reasonable Compensation for a shareholder-employee of an S Corporation?

The IRS requires that S corporations “pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.” Fox Peterson can help you determine what your compensation should be in accordance with IRS guidelines. On the IRS website under the heading of “S Corporation Compensation and Medical Issues”, the IRS states “The key to establishing reasonable compensation is determining what the shareholder-employee did for the S Corporation”.

So what factors determine what “reasonable compensation” is for a shareholder-employee? First we look at the source of the S Corporation’s gross receipts. Gross receipts are typically broken into the following three major sources:

  1. Services of shareholderReasonable Compensation Shake
  2. Services of non-shareholder employees
  3. Capital and equipment

If most of the income and profits are from the personal services of the shareholder, then most of the profit distribution should be allocated as compensation. If the majority of gross receipts and profits come from non-shareholder employees or capital and equipment, then a lower amount of the profit distribution can be allocated as compensation.

IRS auditors are also instructed that the “shareholder employee should also be compensated for administrative work performed for the other income producing employees or assets.” For example, a manager may not directly produce gross receipts, but he assists the other employees or assets which are producing the day-to-day gross receipts.

Some factors in determining reasonable compensation:

  1. Training and experienceReasonable Compensation Training
  2. Duties and responsibilities
  3. Time and effort devoted to the business
  4. Dividend history
  5. Payments to non-shareholder employees
  6. Timing and manner of paying bonuses to key people
  7. What comparable businesses pay for similar services
  8. Compensation agreements
  9. The use of a formula to determine compensation.

Lastly, the total of reasonable compensation cannot exceed the amount received by the shareholder either directly or indirectly. Accordingly, if the taxpayer only receives $10,000 from the S Corp during the year, the maximum “reasonable compensation” issue is limited to $10,000.

Contact the professionals at Fox Peterson for help in determining what reasonable compensation is for your S Corporation.