Reasonable compensation is a term with which the owners of S corporations become incredibly familiar. That’s because it creates a fine, fine line on which these business owners must delicately tread to avoid costly penalties and interest payments. As their own bosses, S corporation owners need to determine the amount of their own annual salary. It’s important that they take great care in choosing that amount, because of how the IRS may perceive it in relation to the rest of the company’s earnings that year.
Reasonable Compensation for S Corporations
Reasonable Compensation for C corporations and S corporations have different structures, which wind up affecting the way that they’re both taxed. The owner of a C corporation needs to make sure that she gives herself a salary that’s “reasonable” in the sense that it’s not wildly inflated. If the owner of a C corporation gave herself an unreasonably high salary, she would get a tax deduction on that salary, and would be decreasing the corporation’s non-deductible dividend payouts. The IRS would consider this to be an unethical practice, which would be bad news for the owner of the company.
On the other hand, “reasonable” means just the opposite when we’re talking about an S corporation owner’s salary. Unlike C corporations, which are treated as independent entities with their own tax responsibilities, S corporations pay taxes through the owner’s personal tax returns. As such, the owner of the S corporation needs to pay income taxes on his salary, and the rest of the company’s income is accounted for, but not subject to income taxes. Let’s look at some examples:
Example 1: Alison owns a publishing company that is structured as an S corporation. She gives herself a $300,000 salary, and the company profits $700,000 for the year. Alison reports $1,000,000 on her personal tax return for 2014. Typically, both the employer and employee are responsible for 6.2% of the employee’s wage for Social Security tax, and 1.45% each for Medicare tax. However, because Alison is her own boss, she is responsible for the entire 15.3% in taxes. Additionally, she is required to pay 0.9% on $100,000, which is the amount of money she makes in excess of the $200,000 threshold determined by the new, high-income Medicare surtax that was put in effect in 2013. Ultimately, Alison winds up paying nearly $47,000 in these payroll taxes.