Understanding Reasonable Compensation Studies for S-Corps
What Is a Reasonable Compensation Study?
A reasonable compensation study determines how much a shareholder-employee of an S-corp should be paid in salary versus distributions. The IRS requires that shareholder-employees receive a "reasonable" wage for services performed before taking profit distributions, ensuring employment taxes are properly paid.
Why It Matters
IRS Compliance: The IRS scrutinizes S-corps to prevent owners from taking low salaries to avoid payroll taxes.
Tax Efficiency: A proper salary reduces the risk of audits and penalties while maximizing tax benefits.
Industry Benchmarking: A study provides data-driven justification for compensation levels based on job role, experience, and market conditions.
How Reasonable Compensation Studies Work
1. Determine Job Responsibilities
The study evaluates the shareholder-employee’s role in the business, including:
Management duties
Client work
Administrative tasks
Marketing and business development
2. Research Industry Comparisons
A reasonable salary is compared to wages of similar roles in the industry using:
Bureau of Labor Statistics (BLS) wage data
Private salary databases (Payscale, Salary.com)
Industry-specific compensation reports
3. Factor in Business Revenue & Profitability
High-revenue businesses may justify higher salaries.
If multiple owners work in the business, compensation may be split accordingly.
4. Consider Geographic Adjustments
Salaries vary by location, so regional cost-of-living differences are factored in.
5. Assess Compensation Components
A study breaks compensation into:
Base salary (fixed wage)
Bonuses or performance-based pay
Benefits (health insurance, retirement contributions, etc.)
Case Study: IRS Audit on Unreasonable Salary
In Watson v. United States (2012), an S-corp owner paid himself only $24,000 while taking over $200,000 in distributions. The IRS reclassified much of his distributions as wages, resulting in back taxes and penalties.
How to Conduct a Reasonable Compensation Study
Gather job descriptions, industry data, and business financials.
Use third-party compensation tools to benchmark salaries.
Document findings and keep records for IRS compliance.
Adjust salary annually based on business performance and industry changes.
By conducting a proper reasonable compensation study, S-corp owners can avoid IRS scrutiny while optimizing their tax structure.
