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March 13, 2020

What is Reasonable Compensation?

What is reasonable compensation?

Reasonable compensation is an ever-moving target. However, there have been enough test cases to remove some subjectivity from this measure, depending mostly on the industry and total income for each business. 

The IRS asks that all S-Corporation officers (usually the shareholders of the company) take a reasonable salary based on the industry averages (i.e. what would you be paid for your services as a W2 employee on the open job market) and the net income of the business. 

Thanks to our experience in the industry we have come up with several variables to help us determine the right salary to take for you: net income from the business, amount of equity distributed (what's referred to as owner's draw in a sole proprietorship), and estimated personal tax liability.

First, we look at your net income. The IRS requires around 40% of your net income from the company to be taken as wages (generally; certain industries may require more or less), so if you've managed to make $50k in net income during the year we would want your salary to be at about $20K with the associated taxes paid. This not only reduces your net income by the $20k salary but also the Social Security and Medicare taxes paid by the business instead of you personally. 

Now we compare that to the amount of equity you've drawn from the business currently; these are your "tax-free" take-home amounts. We don't want to limit you too much on this amount; it is your money after all. But we want to make sure you don’t take too much inequity versus payroll to keep you compliant. We usually like to recommend a 50/50 split between payroll and distributions each year.

Finally, we want to also factor in any personal tax implications that we can. Events such as a secondary income from a spouse or W2 position, investment income, life events, etc. can also have an impact on your overall income tax needs and with close collaboration with your personal tax provider, we can use your business payroll to mitigate potential tax shortfalls.  

Through our sophisticated calculator and intimate knowledge of S-Corps, we are able to properly navigate the reasonable compensation journey to the maximum tax savings benefits.