How to Calculate Reasonable Compensation

As the end of the year quickly approaches its time to review your accounting to get ready for taxes. One issue that causes some people much pain, especially when they get audited, is "Shareholder Reasonable Compensation".

For S-corporation owners it's usually that too little compensation was paid to the shareholder/employee/owner. (All of whom are the same person).

There are a few reasons this happens:

  1. An accountant or Tax preparer told the individual that they could take distributions from their S-Corporation tax free. The individual mistakenly took this to mean they could pay a small salary or none at all.

  2. The shareholder uses their corporate bank account to pay their personal expenses. All of which would be recorded as compensation paid to the shareholder. None of which usually are.

  3. Shareholders treat distributions as loans to themselves. Loans usually have a promissory note or loan document, have a stated interest rate, a due date and penalties for non-payment or default. Shareholder loans usually lack these components.

If you google "Reasonable Compensation" there are thousands of articles on the subject. What they usually do not tell you is how to determine if your compensation is reasonable. The image is an excerpt from IRS Publication 535 that talks about the factors to consider in determining reasonableness.

Tax law changes are tipping the scales and s-corporation rules are s becoming increasingly more difficult to comply with. Seek the advice of a tax law professional (such as an attorney or master of tax law) to help you determine your reasonable compensation this year.

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