What is reasonable compensation for corporate officers and why is it important?
The tax laws require officers of corporations to receive “reasonable compensation, as corporate officers such as presidents, treasurers, CEOs and COO as by law employees of the corporation.”
As employees they must receive wages as payroll with the appropriate taxes withheld and employer payroll taxes paid. S-Corporation shareholders lose the IRS Code Section 199A deduction on passthrough income which could reduce passthrough taxable income by up to 20% (if they do not have reasonable compensation of officer shareholders). The IRS can also reallocate distributions and other items to wages should they determine the reasonable compensation rules are not met, thereby making the corporation liable for additional payroll taxes as well as penalties for late payment of these taxes.
The important question is just how much compensation is necessary for reasonable compensation to be archived. “Reasonable Compensation” is the amount a company would have to pay an unaffiliated third party to fill the position and perform the same or similar duties.
If it seems a little subjective that is because it is. Use too high a number for reasonable compensation and you end up paying more payroll taxes than might be otherwise required. Pay too little and if you are audited you may find the IRS requiring you to make adjustments and pay additional taxes and penalties. The only thing we are certain about is that ZERO is never a reasonable amount for officers’ payroll and that the minimum should not be less than minimum wage based on the hours worked. The rest depends on the skills and experience necessary, the kind of business and the amount of profits realized by that business.
If you are a corporate officer of a company where you control your own compensation our best advice is to review your compensation amounts at least annually with your tax advisor.