All You Need to Know About Reasonable Compensation for S-Corps

Under the guidelines and rules of the Internal Revenue Service, fair remuneration is imperative for shareholder-employees and their S corporations

Reasonable compensation has been an issue for S Corps for many years. To date, there have been numerous debates around what is considered reasonable compensation – as the rules on what is considered fair compensation may differ between states and industries. There is no universal calculation to determine the reasonable compensation for shareholder-employees, and understandably, this issue has confused both companies and individual tax filers for a long time.

So, what are the financial implications of being a shareholder working and receiving reasonable compensation as an employee of your S corp? Under the guidelines of the Internal Revenue Service, fair remuneration is seen as “the value that would ordinarily be paid for like services by like enterprises under like circumstances” and is imperative for shareholder-employees and their S corporations. Your corporation is subject to employment taxes on compensation payments for services you provide as an employee.

IRS Guidelines for Shareholder-Employees Receiving Reasonable Compensation

Determining compensation and the tax implications thereof, is complex, including knowing which federal income tax forms to file with IRS. For an S-corporation, the Internal Revenue Service requires you to file a federal income tax return form 1120-S.  Following the guidelines set out in filing this form is essential to protecting yourself as the shareholder-employee and the corporation. It can prevent you and your business from paying unnecessary penalties, fines, and taxes for not reporting money taken from your S-corp for services.

S corps reasonable compensation

How to determine reasonable compensation for S corps

When it comes to determining reasonable compensation for S corps, there is no one-size-fits-all approach to follow. This becomes even more complicated to do when we factor in different state laws, corporation size, and revenue as well as the markets within which the corporation operates.

An S corp can determine reasonable compensation unique to their business, using one of three basic methods.

1. The cost approach

This payment-determining approach is common among small businesses. It is also referred to as the “many hats approach”, as the owner in this type of S corp setup typically performs many functions. This approach compensates the owner for the time spent per function and at the market-acceptable remuneration of each function. This payment method would require accurate time-logging per function and would have to justify payment accordingly.

2. The market approach

This remuneration-determining approach uses “fair market value” within the specific industry as the basis for shareholder-employee payment. It analyzes the owner’s duties within the specific industry and compares them to what like-qualified roles are remunerated within the same field. This approach is best used when owner-shareholders have one defined role within the business.

3. The income approach

This approach can be better understood when thought of as the “independent investor test”. It simply considers whether investors would be in favor of the compensation level of the owner when comparing it to the financial position of the business at large. To determine reasonable compensation using this method, an S corp would have to consider the fair market value at the start of the year in comparison to any increases in that value by the end of the year; and then the business would have to consider a probable return for investors. Once this has been assessed, reasonable compensation for a shareholder-employee can be established.

For shareholders receiving an S Corp salary, the IRS will require them to include the prorate share of their earnings for any given year. You may not be subject to self-employment taxes on any income distribution from your corporation. And your business may not be liable to pay any employment taxes on the distribution you receive. However, the shareholder-employee and the S corp are subject to employment taxes on reasonable compensation for services. It does not matter your title, CEO, or General Manager the IRS considers shareholders as employees if their services are not minor.

Understanding Tax and Employer Deductions for Workers

S corporations can claim deductions on behalf of shareholder-employees for health and accident insurance premiums and report as wages on their W-2 form. If you are a shareholder-employee, you should receive this form, which is subject to income tax withholding. Corporations with multiple shareholders can purchase a group health insurance policy, whereas single members must buy their policies in their names.

Reasonable compensation

If you are the only shareholder-employee of your S corp and pay for health insurance using your own money, you may not be able to claim the above-the-line deduction. Corporations can claim the deduction under specific criteria, including:

  • S corp must purchase the health insurance in its registered name.
  • Shareholder-employee must be covered under the health insurance policy.
  • S corp must report the paid premiums on your W2 form as wages.

A shareholder-employee can claim the above-the-line deduction under these circumstances:

  • S-corporation paid or reimbursed you for paying the health insurance using your funds.
  • S-corp reports the paid premiums as taxable compensation on your W-2 tax form.

Reasonable compensation for an S corp and the shareholder-employee requires financial guidance as it has tax implications for your business. At Fusion CPA we strive to help owners of S corporations follow IRS and GAAP guidelines for determining and reporting wages. Our CPAs offer outsourced accounting services, including bookkeeping, payroll, financial planning, and tax preparation.

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This blog article is not intended to be the rendering of legal, accounting, tax advice or other professional services. Articles are based on current or proposed tax rules at the time they are written and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.