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Alexandria, Virginia 22313


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What is Reasonable Compensation?

A huge question to be addressed by “S” Corporations

Roy A. Ackerman, Ph.D., E.A.


You are running a small business.  However, the definition we are discussing here is whether you have elected to be taxed as a small business corporation (termed an “S” corporation).  When you file Form 2553, "Election by a Small Business Corporation," the IRS, upon approval, send out Letter CP261, "Notice of Acceptance as an S Corporation." If you read that letter carefully (don’t worry, most don’t), you are told that your shareholders are to be paid a reasonable compensation, if they are also employees.  The problem is what is “reasonable compensation”.  Why?

In a nutshell, S Corporations, Partnerships, and LLC’s (either operating as corporations or partnerships)  flow their profits and losses directly to the owners.  So, every penny that is profit, after (legal, documented) expenses becomes a “dividend” to the owners.  That dividend is reported on your 1040 filing using Schedule E; the dividend is taxed as income.  [Of course, if you have a loss, that loss reduces your overall income.] OK, you say, that makes sense, so what?  Well, if you are a partnership, ALL of that money is subject to FICA and FUTA (as well as SUTA). [FICA includes Medicare and Social Security taxes, FUTA  are Federal Unemployment Taxes, SUTA are State Unemployment Taxes.] This is NOT the case for S corporations (or LLC’s electing to be corporations).  Profits and Losses  are not subject to FICA and FUTA.  So, if you (illegally) do not pay your shareholder-employees a salary, then that money would (not legally) flow to the shareholders as a dividend.  NO Social Security, NO Medicare taxes, NO unemployment taxes would be paid on what should have been legitimate wages.   That’s the problem- one the IRS corrects by making ALL of that money subject to FICA and FUTA  [IRS Revenue Ruling 74-44]. (Sorry, Charlie, you can’t call those funds loans to shareholders or distributions other than dividends, either.)  Moreover, you will be subject to failure to deposit, failure to file, and negligence penalties, PLUS interest.  NOT where you want to be, trust me- the penalties range from 20 to 25% of the amounts due.

The first step must be to determine which of the shareholders are considered to be employees.  Any shareholder who provides services to the corporation shall be paid reasonable compensation; ipso facto, that individual is an employee.  Any individual hired in the ordinary course of business is obviously an employee- but that does not mean that person is either an officer or shareholder of the corporation.  Furthermore, in 2008, the IRS published that corporate officers are within the definition of an employee subject to FICA, FUTA, and other income tax withholding.  One could argue that the officer may not be- but only if no services or very, very minor services are accorded to the corporation.  Trust me, they are few and far between.  As a matter of fact, the new instructions for 1120S [Income Tax Forms for Flow-through Corporations] (OK, a few years old now)  clearly state for line 7, “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.”

Let’s look at some numbers, which will put this problem in perspective.  To make it simple, let’s assume our corporation has a single stockholder (very, very bad idea in practice, but we are not discussing that issue here), with no itemized deductions.  The Gross Revenue for the firm was $ 250K, with a profit before taxes of $ 100K. 


No Salary

Low Salary

High Salary



$ 0

$ 30,000

$ 60,000


K-1 (S income)

$ 100,000

$ 67,271

$ 34,976

Don’t forget employer payroll taxes

1040 Adjusted Gross

$ 100,000


$ 94,976

K-1 + Salary






Taxable Income

$ 91,050

$ 88,321

$ 86,026


Federal Income Taxes

$ 19,479

$ 18,681

$ 18,065


FICA (employer/employee)

$ 0

$ 4,590

$ 9,180


FUTA/SUTA (max 6.2%)

$ 0

$ 434

$ 434

Of first $ 8000

Total Taxes Paid

$ 19,479

$ 23,705

$ 27,679



Before penalties and interest




 So, now we are back to our original problem:  What is reasonable compensation?   Well, there are no hard and fast rules.  Things such as training, experience, duties, responsibilities, time involvement, payments to non-shareholder employees, and what comparable businesses pay for similar services all come into play.    

If you are doing it yourself, a simple guide is, “What would you pay someone else to do your job?” But, that’s way too simple.  If you are starting out, you would not be able to get someone to do your job for the money you have available.  If you are in a downturn, the employee would probably NOT take a severe reduction in salary to accommodate the business; you, however, would (whether or not you want to do so).  So, there are other differences to accommodate.

We use a variety of computations.  The first pass includes a percentage of the gross and net revenues of the firm.  We compare these to other firms, to insure that the compensation is in bounds.  Next, we would do a salary search; a good place to start is You can plug in a title and a zip code and be provided with a range of values.  You can search professional journals, who generally publish a salary guide once a year.  It is also important to relate the officer’s salary to business sales; for that you can go to  (This site is used by the IRS to determine the overall reasonableness of expenses; it is NOT an official use, however.) You can also try using the Bureau of Labor Statistics (US Department of Labor) for their salary data found at This is arranged by occupation, metropolitan region, among other variables.  (Try to keep within the 25th and 75th percentiles.)  

In the end, you are left with making reasonable assumptions to achieve that reasonable compensation. It is not perfect- but NOT doing it will cost you plenty.




The Adjuvancy, LLC

 Post Office Box 25766

Alexandria, Virginia 22313



Copyright © 2016 The Adjuvancy, LLC
Last modified: October 27, 2016