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What is reasonable compensation?

Updated: Jun 19, 2023


In United States legalese, Reasonable Compensation is a concept that refers to the fair and just compensation that an employee should receive for their services. This concept is particularly important for small business owners, S-corporations, and other entities that are structured in such a way that the owners are also employees.


In this blog post, we will provide a comprehensive layman’s overview of what Reasonable Compensation is, when it applies, and how it is calculated.


Defining Reasonable Compensation


Reasonable Compensation refers to the amount of money that an employee would typically earn for performing the same duties and responsibilities as the owner of the business. The concept of Reasonable Compensation is designed to ensure that owners of businesses are not using their status as owners to pay themselves less than what they would earn if they were hired as employees. Essentially, the IRS doesn’t want you to become an S Corp and pay yourself minimally to avoid self-employment taxes or pay yourself aggressively as a C Corp to reduce your net income.


When Does Reasonable Compensation Apply?


Reasonable Compensation applies to small business owners who are also employees of the company, and it is particularly relevant to S-corporations. In an S-corporation, the owners are considered employees, and they must receive reasonable compensation for the services they provide to the company.


The IRS considers Reasonable Compensation to be an important concept because it ensures that business owners are not using their status as owners to avoid paying payroll taxes. If a business owner pays themselves a low salary and takes the rest of their compensation in the form of dividends, they may be able to avoid paying Social Security and Medicare taxes, which are paid on wages but not on dividends.


How to Calculate Reasonable Compensation


Calculating Reasonable Compensation can be a complex process, and it is important to consult with a tax professional to ensure that the calculation is accurate and complies with IRS guidelines. Some factors that may be taken into consideration when determining Reasonable Compensation include:


  • The amount of time the owner spends working for the company

  • The duties and responsibilities of the owner

  • The experience and qualifications of the owner

  • The compensation paid to other employees who perform similar duties


The calculation of Reasonable Compensation will vary depending on the specific circumstances of the business and the owner. It is important to work with a qualified tax professional, like the professionals at Iota Finance to help ensure that the calculation is accurate and compliant with IRS regulations.


Conclusion


In conclusion, Reasonable Compensation is a crucial concept for small business owners and S-corporations. It ensures that owners are not using their status as owners to avoid paying payroll taxes and that they are being paid a fair and just salary for their services. While the calculation of Reasonable Compensation can be complex, it is important to work with your CPA or schedule a free consultation with a CPA at Iota Finance to ensure that the calculation is accurate and complies with IRS guidelines.

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