S Corp Owners: Are You Paying Yourself Legally? (And Avoiding Costly Penalties)
- STEVEN C RESUTA CPA
- Jun 3
- 3 min read
Updated: Jun 9
By Steven C Resuta, CPA - as published on LinkedIn
Many S Corp owners are unaware of a critical tax requirement: if you actively work in your business, you must pay yourself "reasonable compensation" via payroll. This isn't just a suggestion; it's a tax law mandate, and the IRS even highlights it in their welcome letters to new S Corporations.
Overlooking this can lead to significant headaches and costly penalties down the line. Let's break down what "reasonable compensation" means and why it's so important.
What is Reasonable Compensation?
Simply put, it's the salary or wages you pay yourself as a shareholder for the services you provide to your S Corporation (or LLC taxed as an S Corp). It's about ensuring you're compensated fairly for your work, just as any employee would be.
Key Factors in Determining Your Reasonable Compensation:
The IRS considers various elements when assessing if your compensation is "reasonable." Here are some fundamental factors:
Duties and Responsibilities: What do you actually do for the business? More time-consuming, complex roles requiring specialized knowledge typically warrant higher compensation.
Qualifications and Experience: Your professional background, education, and credentials directly impact your market value. Highly skilled individuals command higher salaries.
Industry Standards: What's the going market rate for comparable positions, skills, and responsibilities in businesses of similar size within your industry? Benchmarking is crucial.
Business Location: Geographic location plays a role. Salaries in high-cost-of-living areas (e.g., New York, California) are generally higher than in rural regions like Central Pennsylvania.
Compensation of Other Employees: Compare your compensation to that of other non-owner employees in your business who perform similar functions.
While these are core considerations, many other factors can influence determination. For highly profitable businesses, a formal "reasonable compensation study" may even be advisable to ensure compliance.
Why is Reasonable Compensation So Crucial? The IRS Perspective.
Failing to pay yourself reasonable wages as an S Corp owner can have severe tax implications if the IRS audits your business. They may:
Reclassify Distributions as Wages: The IRS can reclassify past distributions (profits taken out of the company) as wages. This means you'll be on the hook for unpaid Social Security and Medicare taxes (15.3% on both the employee and employer sides) on the reclassified amount.
Impose Penalties and Interest: You'll face penalties and interest on any underpaid Social Security and Medicare taxes.
Disallow Business Deductions: The IRS might disallow certain business deductions, increasing your past tax liability, along with added interest and penalties.
Trigger Further Scrutiny: A finding of unreasonable compensation in one year can open up other tax years for similar reclassification issues, compounding your tax burden and penalties.
Protect Your Business: Act Now!
Compliance with fundamental tax rules like reasonable compensation is paramount to your S Corp's financial stability and cash flow. It's a cornerstone for building a strong, thriving business and protecting your investment for years to come.
Unsure if you're meeting this crucial requirement? Don't wait until an audit brings it to light. Proactive tax planning is key.
Contact a qualified tax professional today to discuss your specific situation and ensure your S Corp is fully compliant. Getting ahead of these issues can save you significant time, money, and stress.
Ready to ensure your S Corp is compliant and protected? Start proactive tax planning today with one phone call to Steven C. Resuta, CPA at 570-672-1040 Ext. 101! You can also visit my site: www.Resuta.com.
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