Reasonable Compensation 101: What Every Business Owner Needs to Know

Do you know what reasonable compensation is and why it is critical for business owners to “know their number” related to it? If not, it’s time to find out!

Reasonable compensation is the calculation of how much your salary should be as a business owner (and what any other co-owners of the business should be paid.) While this may sound simple (You can just estimate it right? Wrong!) few business owners are aware of this important requirement. In fact, failure to do this calculation correctly can lead to serious future tax implications.

This is because there are several implications of not calculating reasonable compensation correctly, including paying too little or too much payroll tax and potentially setting yourself up to be flagged in an income tax or payroll tax audit. For example, if you own a business, a key strategy to reduce your self-employment tax obligations is to pay yourself as an employee of the business on payroll. 

However, if your business is not using accurate reasonable compensation numbers to determine your salary (or if you are ignoring reasonable compensation altogether). As a business owner, it is critical to understand that reasonable compensation is so much more than just a method for determining compensation for business owners. In reality, it affects everything from payroll taxes, tax planning strategies, entity selection, Social Security Insurance, disability income, and more. 

Here are six key reasons why every small business needs accurate reasonable compensation calculations.

1. Determining accurate reasonable compensation is the law for S-Corps and other businesses. As stated by the IRS instructions for tax filing for S-Corps, “distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” This means that it is the law that business owners need to calculate reasonable compensation to declare payroll expenses for the salary of their owners and/or officers. This calculation will impact the amount of payroll and income taxes due, so it is important to keep this figure as accurate as possible
2. Not having accurate reasonable compensation can leave you vulnerable to wage reclassification and additional payments. As a business owner, if you take distributions and have not paid yourself any wages, or if the wages you've paid yourself are deemed to be too low by the IRS, you risk having all of your distributions reclassified as wages which carries hefty penalties, interest, and back taxes. The best way to protect yourself is to have your accountant run a reasonable compensation analysis for you every year and keep the report on file and easily accessible should the IRS come knocking. The alternative is that the IRS could use its authority to reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes). Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense that are subject to employment taxes.
3. Reasonable compensation can help you clearly see the value of any business you may be acquiring or selling. By ensuring officer salaries are indeed reasonable, you will have true clarity on the actual profitability of a company and therefore its market value. This can prevent overpayment or underpayment for the business.
4. Changes in your family, health, or other personal situation may impact your true reasonable compensation. For example, a divorce may require the accurate calculation of reasonable compensation for determining the value of your business. Hand-in-hand with life changes goes the ultimate question of how to value your business when you die, and the sale or divesting of it to heirs, shareholders, and other potential third-parties becomes relevant. Having an accurate and objective reasonable compensation calculation will make the process of business valuation much easier in what is often a very stressful situation.
5. Your future retirement income is also affected by the accuracy of your reasonable compensation calculations. What you claim as compensation and ultimately pay payroll taxes on will impact your Social Security payouts later on. If you pay yourself unrealistically low wages now to save payroll taxes, you will not receive the Social Security checks you may anticipate. Instead, you will receive the equivalent of the self-employment taxes you paid at lower wages. 
6. Reasonable compensation can have a critical impact on your income if you need disability benefits in the future. Similar to your retirement payouts from Social Security, your reasonable comp impacts disability insurance payments, too. Paying too little means you will be left with a shortfall in disability payments, which could have dire consequences.

Based on the reasons above, you can see why every business needs accurate, third-party verified reasonable compensation calculations. Doing so is key for protecting you and your business from the financial and audit risks identified above. You can obtain these calculations from your accountant if they are well-versed in how to do them, or you can use RCReports which is the only software available to provide accurate and IRS defensible reasonable compensation calculations. It is not advisable to try to calculate reasonable compensation manually without the use of proper employment market data.