Key Takeaways
- Shareholder-employees must receive reasonable compensation for services.
- The IRS scrutinizes S corps to prevent wage avoidance schemes.
- Unreasonably low wages can result in reclassification and payroll tax assessments.
- Factors include comparable salaries, time devoted, duties performed, and profitability.
- There is no official safe harbor (60/40 is a guideline, not a rule).
- Zero wages for an active shareholder-employee is a red flag.
Reasonable Compensation
Why This Matters for the Exam
Reasonable compensation is the most litigated S corporation issue. The exam tests why it matters, what factors determine reasonableness, and the consequences of non-compliance.
Expect at least 2-3 questions on reasonable compensation.
The Issue: Wages vs. Distributions
| Payment Type | Subject to Payroll Tax? |
|---|---|
| Wages (W-2) | Yes (Social Security + Medicare) |
| Distributions (K-1) | No |
The Temptation: Pay low/no wages, take all income as distributions to avoid payroll taxes.
The Problem: This is illegal if the shareholder provides services to the corporation.
Payroll Tax Savings (The Motivation)
| Tax | Rate | Wage Ceiling (2024) |
|---|---|---|
| Social Security | 12.4% (6.2% each) | $168,600 |
| Medicare | 2.9% (1.45% each) | Unlimited |
| Additional Medicare | 0.9% | Over $200k/$250k |
Example: $100,000 wages vs. distributions:
- Wages: ~$15,300 payroll taxes.
- Distributions: $0 payroll taxes.If shareholders provide services, they must receive reasonable wages.
What Is Reasonable Compensation?
Compensation that comparable businesses would pay for similar services.
| Factor | IRS Consideration |
|---|---|
| Training and experience | Skills the shareholder brings |
| Duties and responsibilities | What work they perform |
| Time devoted | Hours worked for the business |
| Comparable salaries | What similar positions pay |
| Company profitability | Ability to pay |
| Dividend history | Pattern of distributions |
| Compensation agreements | Documented arrangements |
Safe Harbor?
There is NO official IRS safe harbor. However:
| Guideline | Description |
|---|---|
| 60/40 rule | Sometimes cited (60% wages, 40% distributions) |
| Not an IRS rule | Just a planning guideline |
| Best practice | Document with salary studies |
Red Flags for IRS Audit
| Red Flag | Description |
|---|---|
| Zero wages | Active shareholder takes no salary |
| Minimal wages | Salary far below market rate |
| Large distributions, low wages | Obvious avoidance pattern |
| Only employee is shareholder | Clear services rendered |
| High-profit business | Can afford reasonable wages |
IRS Consequences
| Consequence | Description |
|---|---|
| Reclassification | Distributions recharacterized as wages |
| Back payroll taxes | Employer + employee portions |
| Penalties | Failure to deposit, failure to file |
| Interest | On unpaid amounts |
| Potential S status loss | In extreme cases |
Documentation Best Practices
| Practice | Description |
|---|---|
| Salary survey | Research comparable positions |
| Written agreement | Employment contract |
| Board minutes | Document compensation decisions |
| Job description | Document duties performed |
| Time records | Track hours devoted |
Real-World Scenario
Scenario: An S corp has one shareholder who works full-time as a marketing consultant. The business earns $200,000. The shareholder takes $0 wages and $200,000 in distributions.
- IRS position: Reclassify a reasonable portion as wages (perhaps $80,000-$120,000 based on comparable salaries).
- Consequence: $80,000 × 15.3% = ~$12,240 in payroll taxes owed, plus penalties and interest.
- Better approach: Pay reasonable wages (e.g., $90,000), take $110,000 as distributions.
On the Exam
Expect 2-3 questions on reasonable compensation, typically:
- Rationale Questions: "Why does the IRS require reasonable compensation?"
- Factor Questions: "Which factor does the IRS consider?"
- Consequence Questions: "What happens if wages are unreasonably low?"
The key is to remember: Shareholder-employees must receive reasonable wages. No safe harbor. Zero wages = audit target. Consequence = reclassification + payroll taxes + penalties.
Why does the IRS require reasonable compensation for S corporation shareholder-employees?
Which factor does the IRS consider when determining reasonable compensation?
What is the consequence of paying unreasonably low wages to a shareholder-employee?