Why Reasonable Compensation Matters: A Guide for Business Owners

Compensation is a critical issue for business owners to address.  It’s not just about paying employees or shareholders—it’s about ensuring that YOUR compensation is aligned with tax regulations and industry standards. Not doing so can result in avoidable stress and financial hardship. This is where reasonable compensation reporting comes in.

In this post, we detail the ins and outs of reasonable compensation, the reporting of it, and why it’s essential to ensure you get it right!

What is Reasonable Compensation Reporting?

Reasonable compensation refers to the concept of ensuring that the salary or wages you pay yourself (or any other key employee) is fair and justifiable for the services provided. It’s a key consideration for tax purposes, particularly for businesses structured as S Corporations, partnerships, or closely-held businesses, and for nonprofit organizations with high-paid executives.

The IRS mandates that S corporation owners who are also employees must receive a “reasonable” salary for their services, which is subject to payroll taxes. Reasonable compensation is intended to reflect the market value of the work performed, considering factors like industry standards, job responsibilities, experience, and geographical location. If the IRS determines the compensation is not reasonable—such as when a business owner pays themselves a very low salary to avoid payroll taxes and takes large distributions instead—they may reclassify those distributions as wages and impose penalties.

Why Does It Matter?

  1. IRS Scrutiny and Penalties
    Failure to properly report reasonable compensation can result in serious financial consequences. The IRS may audit your business and reclassify distributions as wages, which means you would owe additional payroll taxes, penalties, and interest. Business owners who don’t pay themselves a reasonable salary may also face penalties for underreporting their income.
  2. Avoiding Tax Issues
    When the IRS finds that compensation isn’t reasonable, they may seek back taxes on those misclassified distributions. For example, if a business owner takes a large distribution but a minimal salary, the IRS might consider the distribution to be wages, leading to an unexpected tax bill. Getting it right from the start helps you avoid unnecessary tax issues down the road.
  3. Ensuring Fairness for Employees
    If your business has employees other than yourself, it’s important to set reasonable compensation practices to maintain fairness. Paying yourself an unreasonably low salary could raise questions about how you’re compensating other employees, leading to dissatisfaction or even legal challenges. Fair pay practices help you attract and retain talented employees while keeping morale high.
  4. Maintaining Industry Standards
    Setting reasonable compensation is also crucial for staying competitive within your industry. If your salary or wages fall far below what’s typical for similar roles, it may be difficult to attract qualified talent. On the other hand, paying above market rates without justification can create financial strain on your business.

Tips for Getting It Right

  • Document Everything: Keep records of how you arrived at your compensation decision. This documentation can be crucial if the IRS ever questions your reported compensation.
  • Work with a Professional: Consider consulting with a financial advisor or tax professional to help determine what constitutes reasonable compensation. They can help you evaluate industry standards, take your business’s finances into account, and ensure that your salary is in compliance with tax laws.
  • Review Annually: As your business grows and changes, your compensation structure may need to be adjusted. Regularly review and update your compensation strategy to ensure it remains appropriate.

Conclusion

Accurate reasonable compensation reporting is essential for business owners (especially if you are a S Corporation or other closely held entity). Getting it right from the start can save you money and unnecessary stress, allowing you to focus on what really matters—growing a successful business.

Up until now having an IRS acceptable compensation study to validate your W2 was a lengthy and costly proposition.

Davis & Hodgdon CPAs is excited to unveil a new tool that can generate reasonable compensation reports at a significantly lower cost to our clients!  Please reach out to us today if you would like to find out how we can help you by generating these reports which we recommend performing every few years.

Davis & Hodgdon CPAs works with individuals and business owners to keep more of what they earn. Our accountants have the experience required to make sure that nothing is missed! For more information or to set up an appointment please reach out to us today.

Recipients should not act on the information presented without seeking prior professional advice. Additional guidance may be obtained by contacting Davis & Hodgdon CPAs at 802-878-1963 (Williston) or 802-775-7132 (Rutland).

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