Are You Being "Unreasonable" About Your Own Compensation?
By Jennifer McNett, CPA
Manager, Tax Services

In recent years, the Internal Revenue Service has focused more and more on shareholders of S corporations and the salaries they are paying themselves. The IRS has always considered that shareholders must pay themselves a reasonable wage for services they provide to their companies. Various regulations and court cases over the years have supported this. However, we have recently begun to see more aggressive enforcement of these rules and regulations through IRS examinations. If you are a shareholder, how much should you pay yourself? What constitutes “reasonable” compensation?

Numerous court cases have proved that it is unreasonable to pay no salary to employee shareholders actively involved in the business. Arguments that the shareholders are not even employees have also failed to hold up in court. These are the “easy” cases the IRS was mainly focused on in the past.

One case helped establish several factors that you can use to help you determine if your salary is reasonable (Elliotts, Inc. v. COMM 52 AFTR 2d 83-5976).

1. Role in the Company – What is your role in the company, and does your salary compensate you fairly for your job responsibilities? You can also compare compensation and duties across years to determine if salary increases or decreases are appropriate when your role changes.

2. External Comparison – Make an external comparison of salaries in your company to other similar companies in the same industry.

3. Character and Condition of Company – What is the character and condition of the company? Are there complexities to the business or general economic conditions that would affect pay?

4. Conflict of Interest – Employees who are also owners of a company usually have influence over their own salary. This creates a conflict of interest. So you must look at the salary from arm’s length to determine if it is reasonable. In other words, if the employee who was performing these duties was not an owner of the company, would it still be reasonable for the company to be paying them this salary?

5. Internal Comparison – Do an internal comparison of salaries. How does the salary of the shareholder compare to other employees of the company? Often the shareholder is responsible for much more than the average employee, so a larger salary would make sense. But if the shareholder does not have as much responsibility, are they being paid comparatively? Also, look at how the salaries have changed in the past few years and why.

The most important thing when determining salaries is to have support for your position. Shareholders should not have a random or estimated salary. Shareholders should consult their tax advisors to determine the best strategy for calculating reasonable compensation.

For additional information, please contact Jennifer L. McNett at (317) 613-7857 or email: [email protected]