S-corp reasonable compensation: what every tax preparer should know

When your S-corp clients blur the line between distributions and wages, the IRS takes notice. Understanding how to determine and defend reasonable compensation can mean the difference between smooth sailing and a stressful audit. 

By studying how the IRS examines these cases and how the courts have ruled, you’ll be ready to spot potential trouble before it starts.

Below, you’ll find a few of the top questions from a recent webinar on the topic and their corresponding answers. If you choose to watch the on-demand version of this webinar, you can access the full recording and the entire list of Q&As.    

Q: What is reasonable compensation for S corporation shareholders?

A: Reasonable compensation is the amount an S corporation must pay a shareholder-employee for services performed if distributions are made. The IRS defines it as the value that would ordinarily be paid for similar services by similar businesses under similar circumstances. IRS guidance on the topic includes FS-2008-25, the S Corporation Audit Technique Guide (ATG), and Revenue Ruling 74-44. The IRS evaluates reasonable compensation by looking at what the shareholder actually did and the economic value of those services, rather than their theoretical availability.

Q: Why is reasonable compensation important for S corporation shareholder-employees?

A: Shareholders who perform services must receive reasonable compensation as employees rather than just distributions, which are not subject to employment taxes. Underpaying wages to avoid payroll tax can result in IRS penalties and the reclassification of distributions as taxable wages.

Q: Who is required to receive reasonable compensation in an S corporation?

A: Any shareholder who provides substantial services to the S corporation and materially participates in its operations must be paid a reasonable wage since they are considered employees of the corporation. Section 3121(d)(1) and Reg.§31.3121(d)-1(b) define employee to include any officer of a corporation.

Q: What factors does the IRS consider when evaluating reasonable compensation?

A: The IRS considers multiple factors, including:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to nonshareholder employees
• Timing and manner of paying bonuses
• Comparable compensation paid by similar businesses
• Compensation agreements
• Use of a formula to determine compensation

To learn more about reporting for reasonable compensation for S corporation shareholders, you can watch our on-demand webinar. NATP members can attend for free, depending on membership level! If you’re not an NATP member and want to learn more, join our completely free 30-day trial.