If you’re a business owner of a C corporation or S corporation, setting your salary involves more than just choosing a number that sounds right. The IRS pays close attention to how much you’re paying yourself, and if your compensation is deemed too high or too low, it could trigger audits, reclassifications, back taxes, and penalties. Ensuring your salary qualifies as “reasonable compensation” is essential for staying compliant and protecting your tax deductions.
Why Reasonable Compensation Matters for Business Owners
The IRS expects compensation for shareholder-employees to reflect the market value of the work performed. Paying yourself more or less than what someone else would earn for the same role in a similar business can raise red flags.
C Corporation Owners
Many C corporation owners choose to pay themselves higher salaries because wages are considered deductible business expenses. This reduces the corporation’s taxable income. However, if the IRS finds your salary to be excessive, they may reclassify the excess amount as nondeductible dividends—leading to additional taxes and reduced deductions.
S Corporation Owners
S corporation owners often do the opposite—minimizing wages and maximizing distributions to avoid payroll taxes. But if the IRS determines your salary is unreasonably low, they could reclassify a portion of your distributions as wages, triggering payroll taxes and possible penalties.
Both strategies are under constant IRS scrutiny, making it crucial to align your compensation with industry norms and documented responsibilities.
How the IRS Evaluates Reasonable Compensation
The IRS defines reasonable compensation as “the amount that would ordinarily be paid for like services by like enterprises under like circumstances.” In other words, would your company pay someone else the same amount for doing the work you do?
Here are the key factors the IRS reviews:
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Job duties and responsibilities
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Education, training, and experience
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Time commitment and effort
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Comparable wages in your industry and location
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Overall revenue and profitability of the business
Business owners should periodically assess these factors to make sure their salary aligns with market expectations.
Steps to Help Establish Reasonable Compensation
To protect your business from IRS challenges, take these proactive steps:
1. Benchmark Against Industry Standards
Research what others in similar roles and industries are earning. Use sources like the U.S. Bureau of Labor Statistics, industry salary surveys, and reputable compensation databases. Save your research to demonstrate your salary is grounded in objective data.
2. Create Clear Job Descriptions
Document your roles and responsibilities thoroughly. If you wear multiple hats—such as CEO, marketing strategist, and financial planner—your job description should reflect this. A comprehensive list strengthens your justification for higher compensation.
3. Maintain Proper Corporate Records
Hold official meetings to review and approve compensation. Record all decisions in board minutes to show your salary was determined through a formal, documented process.
4. Review Compensation Annually
As your business evolves, so should your salary. Conduct a yearly compensation review that factors in company growth, profitability, your workload, and market changes. Document the rationale for any adjustments to support your case during an audit.
Ongoing Compliance is Key
Setting reasonable compensation isn’t a one-and-done activity—it requires ongoing evaluation and documentation. Staying proactive will not only help avoid IRS penalties but also align your compensation strategy with the long-term goals of your business.
Need Help with Compensation Planning?
We can assist you in benchmarking your salary against industry standards, creating detailed job descriptions, compiling supporting documentation, and implementing a formal process to establish and review compensation decisions. Our goal is to help you ensure IRS compliance while aligning your compensation strategy with your company’s financial health and long-term objectives. Don’t leave your salary decisions open to IRS scrutiny—proactively manage them with expert support. Reach out to us today for personalized guidance and protect your business from unnecessary tax exposure, penalties, and reclassification risks.
