By: John S. Morlu II, CPA
When running a business, how you set your compensation matters—especially if you’re a business owner working within an S corporation or C corporation. The IRS closely examines owner compensation to ensure it’s “reasonable.” If it isn’t, they may reclassify your earnings in ways that could lead to additional taxes, penalties, and interest. Let’s break this down in simple terms.
Why Does the IRS Review Compensation?
The IRS pays close attention to how business owners pay themselves, particularly in S corporations. Here’s why:
- S corporations allow profits (after deducting owner compensation) to avoid self-employment taxes.
- Self-employment taxes for 2024 are quite high—15.3% on earnings up to $168,600, as shown below:
| Type of Tax | Tax Rate | Earnings Base |
| Social Security | 12.40% | Up to $168,600 |
| Medicare | 2.90% | All earnings |
| Medicare – Additional | 0.90% | Above $200,000 (single); $250,000 (married) |
Because of this, S corporation owners may be tempted to take a low salary and instead receive more income as distributions, which aren’t subject to self-employment taxes.
But if the IRS believes your salary is unreasonably low, they can reclassify some of your distributions as salary. This means you might owe back taxes for Social Security, Medicare, and Federal Unemployment Tax (FUTA), along with penalties and interest.
For C corporations, the IRS looks at the opposite problem: owners paying themselves excessively high salaries to avoid corporate taxes. Since dividends (profits paid to shareholders) are not tax-deductible, some owners might try to minimize dividends and instead take larger salaries. In these cases, the IRS can reclassify a portion of the salary as dividends, which would increase the corporation’s taxable income.
What Does “Reasonable Compensation” Mean?
The IRS defines reasonable compensation as payment that reflects the services actually performed by the owner. The key rule comes from Section 162(a)(1) of the tax code, which states that businesses can deduct salaries or other compensation if they are:
1. Ordinary and necessary for the business.
2. Reasonable and purely for services provided.
In simpler terms, the salary must be fair for the work done, based on what someone with similar skills, experience, and responsibilities would earn in the open market.
How to Determine Reasonable Compensation for S Corporations
To figure out what is “reasonable,” the IRS looks at where the S corporation’s income is coming from. There are three main sources:
1. The services performed by the shareholder (owner).
2. The services performed by non-shareholder employees.
3. The business’s equipment or capital.
If most of the income is generated by the owner’s work, a large part of the earnings should be considered compensation. If the income comes from employees or equipment, then distributions (in addition to a fair salary) may be appropriate.
Owners should also consider their contributions to running the business, even if they’re not directly generating revenue. For example, a manager may not make sales but plays a critical role in supporting the team.
Factors the IRS Uses to Determine Reasonable Compensation
The IRS considers several factors when evaluating whether an owner’s compensation is reasonable:
- Training and experience: How skilled and qualified is the owner?
- Duties and responsibilities: What role does the owner play in the business?
- Time and effort: How much time does the owner spend working?
- Dividend history: How much has the company paid out in distributions?
- Payments to other employees: Are non-owner employees fairly compensated?
- Bonuses: Are key employees receiving bonuses, and how are they paid?
- Market comparisons: What do similar businesses pay for similar work?
- Compensation agreements: Are there written agreements about pay?
- Formulas for pay: Is compensation calculated using a clear, consistent method?
Ultimately, the IRS looks at what someone would reasonably earn for similar work in the same industry. If the business’s revenue comes mostly from the owner’s work, their compensation should reflect that.
Why Reasonable Compensation Matters
Setting a fair salary isn’t just about following the law—it’s also good business practice. Fair compensation ensures you:
- Stay compliant with tax rules.
- Avoid costly penalties and audits.
- Build trust with partners, employees, and investors.
If you’re unsure about what constitutes reasonable compensation for your role, working with a tax professional can help. They can guide you in setting a fair salary, balancing distributions, and meeting all IRS requirements.
Reasonable compensation is a critical factor for small business owners, so make sure you’re getting it right to protect your business and your finances.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
• ReckSoft (www.ReckSoft.com): AI-driven reconciliation software revolutionizing financial accuracy and efficiency.
• FinovatePro (www.FinovatePro.com): Advanced cloud accounting solutions empowering businesses to thrive in the digital age.
• Fixaars (www.fixaars.com): A global handyman platform reshaping service delivery and setting new benchmarks in convenience and reliability.
Under his strategic vision, JS Morlu continues to set the gold standard for technological excellence, efficiency, and transformative solutions.
