So now, exactly what is “reasonable compensation?”

That’s a question many business owners ask as part of the tax planning process. That is, business owners who are also employees of their corporations. And the answer as to what “reasonable compensation”  – as determined by the IRS on audit – is based on the facts and circumstance based on IRS guidelines. And what’s “reasonable” depends on whether that owner is an employee of a C-corporation or an S-corporation.

If the individual is a C-corporation employee, and their compensation is not “reasonable”, then there’s a double whammy. No deduction to the corporation, and a taxable dividend to the employee/shareholder. Mitchell Port in his article, Is Your Compensation Reasonable Or A Disguised Dividend?, on his California Tax Attorney Blog nicely covers what happens if a C-corporation owner has too much compensation.

But the flip side is not enough compensation which is a tax issue about which S-corporation owner-employees need to be careful. Distributions from an S Corp are not subject to FICA and Medicare taxes which is a potential savings of approximately 15%. Thus, some owners don’t take much salary in order to minimize payroll taxes on wages. However, on audit the IRS would look to see if compensation is too low, or not “reasonable”. Why is owner compensation an audit priority? The IRS can collect payroll taxes on owner compensation, and the penalty for failing to pay payroll taxes is 100% of the taxes owed.

But the tradeoff to paying more employment taxes is that only compensation that appears on the owner’s W-2 counts as compensation for purposes of determining a contribution to a qualified retirement plan. The larger the salary, the larger the potential retirement plan contribution.