S Corp Reasonable Compensation: What the IRS Requires
As businesses grow, many owners consider electing S corporation (S corp) status to manage taxes more efficiently. While this structure offers benefits, it also comes with important responsibilities, especially regarding how owners pay themselves.
Recently, the IRS has been paying closer attention to S corps and how owners are compensated. As you navigate this transition, here’s what you need to know about S corporation reasonable compensation and how to stay compliant.
What Is an S Corporation and Why Do Businesses Choose It?
An S corporation is not a different type of business entity, but rather a tax election. Eligible businesses, such as LLCs or corporations, can elect to be taxed as an S corp.
Many business owners consider this option as their company grows more profitable, given the potential tax advantages. However, those advantages involve specific rules, particularly for payroll and compensation.
If you're new to how business owners pay themselves, the IRS provides a helpful overview in its guide to paying yourself as a business owner.
S Corp Owners Must Be Both Employer and Employee
When you operate as an S corporation, the IRS views the business as a separate entity from the owner. That means:
The business is the employer.
The owner is an employee.
Because of this, owners must be on payroll and receive wages like any employee.
According to the IRS, S corporation officers who perform services for the business must receive compensation. You can read more in the IRS guidance on S corporation employees, shareholders, and corporate officers.
What Is “Reasonable Compensation” for an S Corp?
One of the primary current areas of IRS enforcement is ensuring that S corporation owners receive reasonable compensation for their work.
The IRS requires that S corp owners pay themselves a salary that reflects the value of the work they perform. This salary must be:
Comparable to what someone else would earn in a similar role
Paid as wages
Subject to employment taxes
Some business owners have historically minimized their salary to lower payroll taxes, taking more income as distributions instead. The IRS is focusing more closely on these compensation practices. The IRS evaluates S corporation compensation by considering duties, experience, time commitment, and industry standards, as outlined in its official resource.
Why the IRS Is Cracking Down on S Corp Salaries
The IRS has increased its focus on S corporations that display certain compensation patterns, particularly when:
Owners are paying themselves little to no salary.
The majority of income is taken as distributions.
There’s no clear justification for compensation decisions.
If compensation is deemed unreasonable, the IRS may reclassify distributions as wages, potentially resulting in back taxes, penalties, and interest. This increased scrutiny is why it’s more important than ever to ensure your payroll setup aligns with IRS expectations.
How to Determine a Reasonable Salary
Determining “reasonable compensation” isn’t one-size-fits-all. It depends on factors like:
Your role and responsibilities
Industry benchmarks
Business size and profitability
Time spent working in the business
Because every situation is unique, there is no single formula, and it’s not something to estimate without guidance.
Work With a Tax Professional
While payroll providers like Payworks Payroll help process payroll, compensation decisions are for tax and accounting professionals. We strongly recommend working with a qualified tax accountant or advisor to:
Evaluate your specific situation.
Determine an appropriate salary.
Ensure compliance with IRS guidelines.
For more detailed information, you can also review the IRS’s official page on S corporation compensation and requirements.
The Bottom Line on S Corp Compliance
Electing S corp status benefits many growing businesses, but it also adds complexity. Paying yourself a reasonable salary is not just best practice; it's required.
If you’ve switched to S corp status or are considering it, now is the time to review your payroll and ensure you meet IRS expectations.
PayWorks is not providing legal or tax advice. The information on this website is for informational purposes only and should not be relied upon as legal or tax advice. You should consult with your own legal and tax advisors before making any decisions about your financial situation.