What Is Reasonable Compensation For An S Corporation?

An S Corp election means the business profits and losses are passed through to the shareholders, who then report them on their individual tax returns. This is very different from a traditional corporation where profits are taxed at both corporate and individual levels.

Reasonable compensation is a term used in the context of S Corporations to refer to the amount of salary or wages that a shareholder-employee should receive for services rendered to the company. This is an important concept because it affects how much income is subject to self-employment tax for shareholders.

What Is An S Corporation?

A special tax election is made for a corporation to become an S Corporation. This tax election allows the company’s profits and losses to be reported on the shareholders’ individual tax returns, avoiding double taxation.

To qualify as an S Corporation, businesses must meet certain criteria set by the IRS, including having no more than 100 shareholders and only one class of stock. If your company is structured as either an LLC or a C Corporation, it can make an election to be taxed as an S Corporation by filing Form 2553 with the IRS. Other typical requirements include:

Shareholders are individuals, estates, or certain trusts. Partnerships and corporations are not eligible to be shareholders.
The corporation must have a tax year that ends on December 31st.
All shareholders must consent to the S Corp election.

An S Corporation provides liability protection for its shareholders by separating personal assets from business liabilities. This means that in case of a lawsuit or bankruptcy, the shareholders’ personal assets cannot be seized to satisfy business debts.

Benefits Of Choosing To Be An S Corporation

An S corporation can offer many benefits to small businesses who are trying to save on taxes and limit liability. Some of these benefits include:

Avoiding double taxation: As mentioned earlier, S corporations allow for pass-through taxation, meaning profits and losses are only taxed at the individual level.
Limited liability: Shareholders are not personally responsible for the debts and liabilities of the corporation.
Strict guidelines: The stringent guidelines set by the IRS for S Corporation status can actually be beneficial for small businesses looking to maintain legitimacy and credibility.
Pass-through losses: In addition to pass-through profits, shareholders can also deduct any losses incurred by the corporation on their individual tax returns.
Credibility: Showing clients and potential customers that you are a legitimate business is imperative. An S Corp designation can help with this.
Flexibility in ownership: S corporations allow for a flexible structure where owners can receive both salary and dividends, allowing for tax planning opportunities.

What Is Reasonable Compensation?

Determining reasonable compensation for shareholders in an S Corporation is essential to comply with IRS regulations and avoid potential penalties. Reasonable compensation refers to the wages that a shareholder-employee earns for services provided to the company. The IRS requires that shareholder-employees receive a fair salary that is comparable to what other employees performing similar duties would receive in the same industry, region, and with comparable skills and experience. It’s important not to set this wage too low in an attempt to pay more distributions and avoid payroll taxes, as this can trigger an IRS audit. Several factors can help determine what constitutes reasonable compensation.

Training and experience: Shareholders with higher levels of education and experience may be able to command a higher salary.
Time and effort: The amount of time and effort put into the company should also be reflected in the salary.
Duties and responsibilities: Shareholder-employees who have more duties and are responsible for critical tasks may warrant a higher salary.
Industry standards: Researching what other companies in the industry pay their employees for similar roles can help determine reasonable compensation.

Regarding the CEO’s compensation, it should be based on the same factors as other shareholder-employees, but it may also take into account the complexity and size of the company. Ultimately, the goal is to ensure that shareholders are not receiving excessive compensation that would be considered unreasonable by the IRS. It’s important to keep detailed records of how this determination was made, as it may be subject to review by the IRS. They should strive for a balance between earning a fair salary and maximizing profits through distributions.

When To File For S Corporation Election

An S Corporation election should be made timely to ensure it applies for the current tax year. Generally, businesses must file Form 2553 within two months and 15 days after the beginning of the tax year in which the S Corporation status is desired to commence. If this deadline is missed, the election will not take effect until the following tax year unless the IRS grants an extension for reasonable cause.

Before making the election, it’s crucial to examine whether the S Corporation structure aligns with your business goals and provides the expected tax benefits. Consulting with a financial expert is advisable to navigate the election process and ensure compliance with IRS requirements.

How To Stay In S Corporation Payroll Compliance

While reasonable wage calculation can keep an S corp in payroll compliance, it’s also essential to stay up to date on payroll tax requirements. This includes timely and accurate tax filings, employee classification, and proper withholding of payroll taxes. It is vital for an S Corporation to keep corporate and personal finances separate to preserve its status. Generally the rule of thumb for a reasonable salary is that it should be at least 60% of total profits. Penalties for not adhering to payroll requirements can be severe, including loss of the S Corporation election status.

It’s also important to have a solid understanding of the tax obligations and implications for both shareholders and the corporation. This includes being aware of any changes in tax laws or regulations that may affect an S Corporation’s tax liability.

Takeaways

Understand the structure: It’s crucial to fully understand the benefits and requirements of operating as an S Corporation to make an informed decision.
File timely: Make sure to file Form 2553 within the specified timeframe to ensure the S Corporation status applies for the current tax year.
Reasonable compensation: Ensure shareholder-employees receive fair and reasonable compensation to comply with IRS regulations.
Maintain compliance: Keep up with payroll tax requirements and maintain clear records to preserve S Corporation status.
Consult professionals: Regularly consult with a tax expert to navigate the complexities of S Corporation regulations and stay compliant with ongoing tax obligations.

Have Questions About S Corp Reasonable Compensation?

Flexkeeper has covered the basics of reasonable compensation for S Corporations, but it’s always best to consult us for specific questions and concerns. We provide personalized advice and guidance based on the unique circumstances of your business and are equipped to provide you a reasonable compensation figure that meets the IRS guidelines noted above. From managing your business’s financials to expert tax planning, we have you covered. Contact us today to learn more about how we can help your business thrive as an S Corporation.