How to Determine Reasonable Compensation and Pay Yourself
You own an S-Corp or a C-Corp, which means that you need to pay yourself a salary. But figuring out how to determine reasonable compensation isn't as simple as just picking a number you like.
If you pay yourself too little, the IRS might reclassify your distributions as wages. But if you pay yourself too much, you could face penalties for excessive compensation. Either way, both mistakes can cost you thousands in taxes, penalties, and interest.
So, here's how to determine reasonable compensation for small business owners, whether you run an S-Corporation or a C-Corporation.
What Is Reasonable Compensation?
Reasonable compensation is what you'd pay someone else to do your job.
If you hired a stranger off the street to handle your exact responsibilities, such as managing operations, meeting with clients, handling sales, overseeing finances, what would you fairly pay them? That's your baseline for reasonable compensation.
The IRS wants to see fair market value for the work you do, and this means that your salary should reflect real-world rates for someone with your experience and skills doing similar work in your industry and location.
AKA, you can't pay yourself $30,000 a year while taking $200,000 in distributions if you're running a consulting business full-time. You also can't pay yourself $400,000 when comparable executives in your industry earn $150,000.
The IRS looks at both extremes and reclassifies payments when the numbers don't add up.
Learn more about how to pay yourself as a business owner.
Reasonable Compensation for S-Corps vs C-Corps
C-Corp and S-Corp owners face opposite temptations when setting their salaries.
C-Corp owners often want to pay themselves higher salaries because wages are tax-deductible business expenses. A $300,000 salary reduces your corporate taxable income by $300,000, which lowers your corporate tax bill.
But if the IRS decides that your salary is excessive compared to your duties and market rates, they can reclassify part of it as dividends. Dividends aren't tax-deductible for the corporation, which means that you lose the deduction and owe more corporate tax.
In turn, S-Corp owners are tempted to pay themselves minimal salaries and take most of their income as distributions. Distributions avoid the 15.3% self-employment tax (Social Security and Medicare), so paying yourself a $40,000 salary and taking $160,000 in distributions saves you on payroll taxes.
The IRS watches for both of these compensation concerns and expects you to set a reasonable salary for yourself as a corporation owner.
How Does the IRS Define "Reasonable Compensation"?
The IRS defines reasonable compensation as the amount you'd ordinarily pay for similar services under similar circumstances.
They look at what third parties earn for comparable work in your industry and region, taking a few different factors into account:
Training and experience: A business owner with 20 years of industry experience and an MBA justifies a higher salary than someone with 5 years and no formal credentials.
Duties and responsibilities: If you're the CEO, CFO, head of sales, and operations manager all rolled into one, your salary should reflect that workload.
Time and effort: Working 60 hours a week running every aspect of your business justifies a different salary than working 20 hours a week in a largely passive role.
Comparable industry salaries: The IRS looks at salary data for similar positions in businesses of comparable size and complexity in your field.
Company income and profitability: You can't justify a $250,000 salary if your business only generates $200,000 in total revenue.
Geographic location: A marketing agency owner in San Francisco commands different compensation than one in rural Ohio, even when doing similar work.
Basically, picking a number that just "feels right" won't hold up during an IRS audit. The compensation paid needs to be reasonable not just for you, but for your market, too.
Learn more about small business taxes for dummies.
How to Determine Reasonable Compensation for Business Owners
1. Research Comparable Salaries
You should start with real salary data for positions that match your responsibilities. Objective market research will help you see what people in similar roles earn in your industry and location.
You can use these resources to gather salary benchmarks:
It's important to look for roles that match what you do at work. For example, if you're a consulting firm owner, search for titles like "Managing Consultant," "Director of Operations," or "VP of Client Services."
Don't just search for "CEO" if that's not what you spend your time doing.
2. Document Your Role
Write out everything you do in your business, the more specific, the better.
For example, your responsibilities may include client acquisition, project management, financial oversight, strategic planning, team supervision, marketing, operations...If you're wearing five different hats, your compensation should reflect that you're doing the work of five different people.
This documentation helps you justify your salary to the IRS, and it also gives you a realistic picture of what you'd fairly pay someone else to do your job.
Learn more about how to pay yourself as an S-Corp.
3. Keep Formal Records
It's important to document your compensation decisions formally through your corporate structure. To do that, you should typically hold board meetings where you discuss and approve your salary.
Record these decisions in meeting minutes with the date, attendees, and the rationale behind the salary amount.
Your meeting minutes should reference the market research you conducted and explain how your responsibilities and experience justify the salary you're setting.
This creates a paper trail showing that your C-Corp or S-Corp reasonable salary was determined thoughtfully.
4. Adjust as Your Business Grows
Your reasonable compensation will likely change as your business changes.
This is because a salary that made sense when you earned $150,000 in revenue doesn't necessarily work when you're earning $500,000.
It's a good idea to review your compensation every year.
Look at how your revenue and profitability changed, whether your responsibilities expanded, and how market rates shifted. If your business income doubles but you keep the same $50,000 salary while taking larger distributions, the IRS WILL notice.
Reasonable Compensation Red Flags
The IRS wants to make sure that you're not manipulating your reasonable compensation for tax savings. Here's what they usually watch out for:
Very low S-Corp salaries: Paying yourself $20,000 and taking $180,000 in distributions.
Very high C-Corp salaries: Paying yourself $500,000 when comparable businesses pay $150,000.
Never adjusting your salary: Keeping a $40,000 salary while your business income triples over five years is unreasonable.
No documentation: You can't explain how you determined your salary or what market research you used.
Salary that doesn't match your work: Paying yourself a full-time executive salary but only working 10 hours a week.
The IRS doesn't audit every business owner, but they do target returns that show obvious attempts to minimize payroll taxes or maximize corporate deductions through unreasonable compensation.
Getting caught means that you'll likely face penalties, interest charges, and the time + expense of dealing with an audit.
Get Help with Reasonable Compensation and Save on Taxes
If you're wondering how to determine reasonable compensation, you now know that it isn't a formula you can plug numbers into and get the right answer. You'll need to research your industry standards and be able to explain why you came to a certain conclusion.
A tax professional can help you do a full reasonable compensation analysis and balance tax savings with compliance, so you're not leaving money on the table or taking unnecessary risks.
If you want to make sure you're paying yourself the right amount and save more on taxes this year, learn more about our services or book a consultation with a member of our team!
