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Is Your S-Corporation Salary Putting You at Risk with the IRS?

The Reasonable Compensation Requirement That Many S-Corp Owners Get Wrong

S-Corporations offer valuable tax advantages for small business owners, primarily through the potential savings on self-employment taxes. However, these benefits come with specific IRS requirements that, if ignored, can lead to significant penalties and back taxes.

One of the most common issues we see with S-Corporation clients is improper salary. Some clients come to us having never taken a salary from their S-Corporation, while others take only a token amount,  perhaps just enough to maximize their 401(k) contributions.

What Does the IRS Consider "Reasonable Compensation"?

The IRS requires S-Corporation shareholders who are active in the business to take "reasonable compensation" for their services. While this term is intentionally vague, years of litigation have established clear guardrails.

The IRS has published guidance that helps define what reasonable compensation is and, perhaps more importantly, what it isn't.

Common Approaches That Will Get You in Trouble

Many S-Corporation owners use simplistic methods to determine their salary that don't stand up to IRS scrutiny:

  • Setting wages as a percentage of revenue
  • Using a 50/50 rule (50% distributions and 50% wages)
  • Following the "Social Security limit rule" (paying yourself just enough to hit the Social Security wage base)

None of these approaches are considered valid by the IRS during an audit.

What Should You Do Instead?

At Monarch Tax & Advisory, we take a data-driven approach to reasonable compensation. We use RC Reports, which uses a three-factor methodology that aligns with IRS guidelines. This approach:

  1. Analyzes your specific duties and time spent on various business functions
  2. Considers appropriate market rates for those functions
  3. Accounts for your business's financial performance and ability to pay

The result is a defensible compensation figure with documentation to support it in case of an audit.

The Real Risk of Getting This Wrong

If you're audited for reasonable compensation and the IRS determines your salary is too low, they can reclassify your distributions as wages. This reclassification means:

  • Back payroll taxes (both employer and employee portions)
  • Penalties for late payroll tax deposits
  • Interest on all amounts due
  • Additional accounting and legal fees to resolve the issue

Year-End Is the Perfect Time to Review

As we approach year-end, this is the ideal time to:

  1. Review your current compensation structure
  2. Conduct a reasonable compensation study if you haven't already
  3. Make adjustments to your payroll before the year closes
  4. Align your compensation strategy with your retirement contributions

Take Action Now

Don't wait for an IRS notice to address this issue. Being proactive about reasonable compensation is far less expensive and stressful than dealing with an audit.

If you'd like to learn more about reasonable compensation studies or discuss whether your current S-Corporation salary structure meets IRS requirements, contact us today.
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