Reasonable compensation (S corp)

Why reasonable comp is required

S corp distributions are not subject to self-employment tax — that's the major tax advantage of the S corp structure over a sole proprietorship or LLC partnership. But this creates a temptation for owner-employees to take all of their compensation as distributions (avoiding payroll tax) rather than as W-2 wages. The IRS pushes back: if the owner-employee performed services for the corporation, a "reasonable" portion of the compensation must be classified as W-2 wages (subject to payroll tax). Distributions can only follow after reasonable wages have been paid.

How to determine 'reasonable'

The IRS and courts apply a fact-specific analysis. Factors include:

• Duties performed: what work does the owner-employee actually do? Compared to what a non-owner would be paid for the same work?
• Industry benchmarks: comparable salaries in the industry, region, and role (BLS data, salary surveys)
• Time commitment: full-time vs part-time vs limited
• Skill and experience: technical expertise, years of practice, certifications
• Business size and profitability: what can the business support?
• Compensation history: how has compensation evolved? Is the owner suddenly taking less in wages?

The audit risk

Reasonable compensation is a top S corp audit focus. Common triggers:

• Zero or very low W-2 wages for an actively-engaged owner. Distributions only.
• Disproportionate growth: profits growing while wages stay flat — IRS will recharacterize.
• Reduction from prior years: dropping owner wages from $200K to $50K while distributions rise — audit risk.
• Recharacterization mechanics: IRS treats the under-paid wages as additional W-2 compensation; corporation owes both halves of payroll tax (12.4% Social Security up to wage base + 2.9% Medicare), plus interest and penalties. Owner's individual tax is also adjusted.
• Defense: contemporary documentation (board resolutions setting comp, salary studies, industry benchmarks)