Setting reasonable compensation is one of the most important — and often overlooked — compliance issues for C corporation and S corporation owners. Getting it wrong can lead to IRS audits, reclassified income, back taxes, penalties, and a major headache.
Whether you’re paying yourself too much or too little, the IRS may scrutinize your compensation strategy. Fortunately, with proper planning, documentation, and market research, you can significantly reduce your risk.
Why Reasonable Compensation Matters
For tax purposes, compensation paid to shareholders must be “reasonable,” meaning it should reflect what an unrelated third party would be paid for similar work under similar circumstances.
For instance, if your company is a C Corporation and you are receiving too high a salary, the IRS may reclassify excess wages as non-deductible dividends. If you are an S Corporation and you are taking a low salary, the IRS may reclassify distributions as wages and assess payroll taxes and penalties.
C Corporation Compensation Strategy
C corp owners are often motivated to pay themselves larger salaries because wages are tax-deductible, reducing the company’s taxable income.
IRS Red Flags for C Corps:
- Compensation far exceeds industry benchmarks.
- Bonuses or salaries not justified by company performance.
- High salaries with little-to-no dividends.
If the IRS suspects excessive compensation to avoid double taxation, it may reclassify part of the salary as a dividend, which isn’t deductible.
S Corporation Compensation Strategy
S corp owners tend to do the opposite and take minimal salaries and larger distributions to avoid payroll taxes.
IRS Red Flags for S Corps:
- Salary is unreasonably low compared to services performed.
- Large distributions inconsistent with reported compensation.
- Lack of formal documentation supporting pay levels.
If caught, the IRS may reclassify distributions as wages, leading to additional payroll tax liabilities and penalties.
The IRS closely watches both strategies because they can be used to avoid taxes. That’s why it’s critical for C corporation and S corporation owners to set compensation that reflects fair market value for their work.
What Does the IRS Consider “Reasonable”?
The IRS uses a multifactor test to evaluate whether compensation is reasonable. While there’s no exact formula, the following factors are routinely examined:
The factors the IRS looks for are:
- Job duties and responsibilities
- Training, experience, and education
- Time and effort devoted to the business
- Comparable salaries for similar positions in your industry and region
- Business size, complexity, and financial performance
- Economic conditions and company salary policy
- Historical compensation trends
- Relationship between the owner or employee and business (arm’s length or non-arm’s length)
- Whether the owner personally guaranteed business debts
Who Does Reasonable Compensation Apply To?
While the focus is typically on business owners, especially those in C and S corporations, the concept of reasonable compensation also extends to certain non-owner employees, particularly in these situations:
- Owner-employees of C and S corps (primary focus of IRS audits)
- Family members employed by the business
- Related parties such as spouses, children, close friends
- Employees in “non-arm’s-length” relationships
- Unrelated employees could be a risk too, if the IRS considers them paid unreasonably or used to manipulate taxable income
An example of a non-owner situation is a business pays a relative $100,000 for administrative tasks valued at $40,000. The IRS may flag and adjust that amount during an audit.
How to Establish and Defend Reasonable Compensation
To avoid IRS scrutiny and support your compensation, follow these best practices:
- Conduct Market Research
- Use salary surveys, industry compensation reports, and resources like the U.S. Bureau of Labor Statistics.
- Compare salaries for similar positions in your geographic area and industry.
- Save this data as backup.
- Create a Detailed Job Description
- List all the roles you perform: CEO, bookkeeper, sales manager, etc.
- Highlight responsibilities, decision-making authority, and workload.
- Maintain Corporate Records
- Hold and document regular board meetings.
- Formally approve compensation and include it in meeting minutes.
- Review Compensation Annually
- Evaluate performance, profitability, and market changes.
- Adjust salaries when needed and document the rationale.
- Consider Third-Party Support
- Independent compensation studies or professional benchmarking services can add credibility.
- Things to Avoid
- Using vague job titles without descriptions
- Setting salary without benchmarking data
- Failing to document compensation decisions
- Paying owners based on cash flow, not value of services
- Taking only distributions from an S corporation
Some Common FAQs About Reasonable Compensation
Q: How often should I review my salary as a shareholder-employee?
A: At least annually. You should consider adjustments if your role changes or the business grows significantly.
Q: What happens if I ignore this and the IRS audits me?
A: You could face reclassification of income, denial of deductions, back taxes, interest, and penalties.
Q: Can I just use profits to pay myself?
A: Not entirely. S corp owners must take a reasonable salary before taking distributions. C corp owners should avoid overcompensating themselves to reduce taxes.
Q: Does “reasonable” mean average?
A: Not necessarily. It should be appropriate to your duties, experience, and business scale, and it should be supported by comparable compensation data.
We Can Help
Determining reasonable compensation is not a one-time decision. It’s a dynamic process that should evolve as your business grows. Taking the time to properly establish, document, and review your compensation protects your company from costly IRS consequences and reinforces good corporate governance.
If you’re unsure whether your current compensation is defensible, or if you’re planning to incorporate and want to avoid mistakes from the start, we can help you set it up the right way.
Call us for personalized guidance, benchmarking studies, and audit-ready documentation.
