Reasonable Compensation, Part 1: A Potential Pitfall for S-Corp Owners

If you’re considering forming an S-Corp (with the aid of a skilled tax lawyer at our firm), you may be motivated by the idea of avoiding self-employment taxes. This is certainly an attractive feature of S-Corp business formation – but it’s not without its potential pitfalls for unaware business owners. One such pitfall is the issue of paying yourself reasonable compensation. In the first of this two-article series, let us look at this concept and the important role it will play when you file your taxes.

A sole proprietor typically has to pay a self-employment tax based on his share of business profits. This SE tax compensates for the percentage of your wages that an employer would normally withhold for Medicare and Social Security. By structuring your business as an S-Corp, you can avoid the self-employment tax – with one very important catch: You must pay yourself a salary before you can distribute any of those SE-proof profits. The salary you receive will then be subject to Medicare and Social Security taxes. While you may still enjoy significant overall tax savings in the long run, you must be able to demonstrate that you received what the IRS considers “reasonable compensation” through that combination of wages and distributions. (We’ll tackle that point in the next article.)

Why is reasonable compensation such an important subject? Many S-Corp owners simply don’t understand this aspect of their tax structure. As a result, they don’t pay themselves any wages at all, instead claiming their business’s total net profit as a personal distribution on their 1040. Such actions can trigger an audit – and they frequently do. This is just one of the many reasons it’s so important to discuss your business formation in detail with an experienced S-Corp attorney.

Next time we’ll discuss how the IRS determines reasonable compensation, and how your tax lawyer on our team can help you plan accordingly.