How do you determine reasonable compensation for an S-corp owner?

The standard

A corporate officer who performs more than minor services and receives, or is entitled to receive, payment is generally an employee. An S corporation must treat payments as wages to the extent they are reasonable compensation for the services provided. IRS guidance also says reasonable compensation must be paid before non-wage distributions are made to the shareholder-employee.

The IRS can reclassify distributions and other payments as wages, which can create payroll tax, penalty, and interest exposure. The governing question is the value of the services performed, not a preferred split between salary and distributions.

The factors the IRS tells S-corps to consider

Current IRS guidance lists the following factors when evaluating reasonable compensation:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

The IRS also emphasizes the source of the corporation's gross receipts. Revenue produced by the shareholder's personal services points toward wages. Revenue produced by other employees, capital, or equipment may support a different allocation, while management and administrative work performed by the shareholder still counts as services.

A practical way to determine the salary

1. Describe the work. List each role, its duties, required skill, and the time spent performing it.
2. Identify what produces revenue. Separate the owner's services from the work of employees and the return on capital or equipment.
3. Find comparable wages. Match the work to credible occupation, industry, and geographic data rather than choosing a percentage of profit.
4. Adjust for the actual facts. Consider experience, hours, responsibilities, business size, and any compensation agreements.
5. Document and revisit the conclusion. Keep the facts, sources, calculation, payroll records, and distribution history together, and update the analysis when the work or business materially changes.

Where wage benchmarks come from

The Bureau of Labor Statistics Occupational Employment and Wage Statistics program publishes annual wage estimates for about 830 occupations. The data can be viewed by occupation, state, metropolitan area, and industry. It is useful evidence of market pay, but it is a benchmark, not an IRS formula and not a substitute for matching the data to what the owner actually does.

Common mistakes

• Using a 60/40 split, or any other fixed ratio, instead of valuing the services performed.
• Taking distributions while paying no wages to an owner who performs substantial services.
• Using a single occupation when the owner performs several materially different roles.
• Treating profit growth by itself as the salary formula. Duties, time, comparables, employees, and capital all matter.
• Keeping no record of the facts and sources used to reach the number.

The analysis should live beside the records that support it. Our guide to defending a reasonable compensation number on audit explains the job description, time evidence, wage benchmark, and review rhythm an owner should keep together.

Current primary sources

Read the IRS reasonable compensation guidance, the IRS officer and shareholder-employee guidance, and the current BLS OEWS tables.