What is reasonable compensation?

Reasonable compensation is the amount S corporation shareholder employees must receive as wages for their services before taking distributions, based on what similar work would command in the market. For professional service firm S Corp owners, reasonable compensation prevents the avoidance of payroll taxes through excessive distributions.

Key characteristics

• Required for S Corp owner employees

• Based on market compensation

• Subject to IRS scrutiny

• Paid before distributions

• Documented with comparable data

• Insufficient amount triggers penalties

Why it matters for professional service firms

S corp owners sometimes minimize salary to reduce payroll taxes, but unreasonably low compensation creates audit risk. The IRS can reclassify distributions as wages, resulting in back taxes and penalties. Professional service firm S-Corp owners must pay themselves a reasonable salary.

Real-world example

Sarah's S Corp had $450,000 net income. Initial approach: $50,000 salary, $350,000 distributions. IRS audit: compensation deemed unreasonable for a consultant generating that income. Comparable data indicated $185,000 reasonable. Reclassification of $135,000 triggered $20,700 in back FICA plus penalties. New approach: annual compensation study documented in corporate minutes.