The reasonable compensation conundrum isn’t just some theoretical tax wrinkle. It has real-world implications that can affect how much you pay in taxes, how much scrutiny your business faces, and your ability to plan accurately for the future.
1. Minimizing Payroll Tax Risk
S corporations benefit from reduced payroll tax liability because distributions (profits) aren’t subject to Social Security and Medicare taxes. However, this benefit becomes a red flag when owner-employees pay themselves an unreasonably low salary to maximize their distributions. Underpaying yourself could land you in hot water with the IRS, resulting in significant penalties.
2. Avoiding IRS Audits
The words “IRS audit” alone can cause any business owner to break into a cold sweat. According to IRS guidelines, businesses that don’t comply with reasonable compensation rules raise audit flags. The penalties for noncompliance can include back taxes, interest, and potential fines—not exactly the financial hit any entrepreneur wants to face.
3. Ensuring Financial Clarity
Establishing a clear, reasonable salary keeps your financial records clean and aligned with IRS expectations. It also makes it easier to plan for business investments, personal income, and long-term growth.
How to Determine Reasonable Compensation
Now that we’ve established why reasonable compensation matters, you’re probably wondering, “How do I figure out what a reasonable salary looks like?” The good news is you don’t have to guess. Consider these steps to determine a fair compensation amount for yourself or other owner-employees in your business:
1. Evaluate the Roles and Responsibilities
Your salary should reflect the work you do in the business. Are you the CEO juggling strategic planning and sales? Or do you only step in sporadically, acting as a part-time consultant? The level of responsibility and time commitment plays a big role in setting a fair salary.
2. Research Industry Standards
Look up average salaries for roles similar to yours in comparable businesses within your industry. Websites like Glassdoor, Payscale, or government resources like the Bureau of Labor Statistics are great places to gather this data.
3. Include Business Size and Revenue
A reasonable salary should factor in the size and profitability of your business. A small startup might start with modest pay for its owner-employee, while an established organization with significant cash flow could afford a higher salary.
4. Account for Regional Differences
Location matters. The same position may command vastly different salaries in New York City compared to a smaller rural town. Adjust your expected compensation accordingly.
5. Consult a Financial Advisor
When in doubt, lean on experts. Accountants and financial advisors experienced in incorporation compensation can provide insights tailored to your business, ensuring compliance with IRS standards.
Common Mistakes to Avoid
Navigating the reasonable compensation rule can be tricky, and unaware business owners often make avoidable errors. Here’s what to watch out for:
Mistake #1: Setting Your Salary Too Low
While it’s tempting to minimize your salary in favor of bigger distribution checks, the IRS views this as a red flag. Be realistic and make sure your salary aligns with your contributions.
Mistake #2: Forgetting to Factor in Benefits
When calculating reasonable compensation, don’t forget to include the value of perks like health insurance or retirement contributions. These elements contribute to the total salary package.
Mistake #3: Neglecting Annual Reviews
Your salary shouldn’t remain static forever. Revisit it annually or whenever your role, business revenue, or industry benchmarks change.
Mistake #4: Relying Solely on Distributions
It’s essential to strike a balance. Overusing distributions for pay without a reasonable salary could trigger IRS scrutiny.
Why Thoughtful Compensation Planning is Key
The reasonable compensation conundrum is one of many considerations when incorporating your business, but it’s one that requires careful planning. By setting a fair and transparent salary for yourself as an owner-employee, you’re not only staying compliant with IRS rules but also setting a strong financial foundation for your business.
At SD Mayer & Associates, we understand that incorporation compensation decisions can feel, well, overwhelming. Our team specializes in guiding small businesses and entrepreneurs through financial intricacies like these, offering custom strategies so you can focus on growing your enterprise.
Take Control of Your Incorporation Process
Thinking about incorporating your business or navigating compensation challenges? Don’t go it alone. Our expert advisors are here to simplify the process and help you confidently tackle reasonable compensation rules. Schedule a consultation with SD Mayer & Associates today and take your business to the next level.
SECURITIES AND ADVISORY DISCLOSURE:
Securities offered through Valmark Securities, Inc. Member FINRA, SIPC. Fee based planning offered through SDM Advisors, LLC. Third party money management offered through Valmark Advisers, Inc a SEC registered investment advisor. 130 Springside Drive, Suite 300, Akron, Ohio 44333-2431. 1-800-765-5201. SDM Advisors, LLC is a separate entity from Valmark Securities Inc. and Valmark Advisers, Inc. Form CRS Link
DISCLAIMER:
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The services of an appropriate professional should be sought regarding your individual situation.
HYPOTHETICAL DISCLOSURE:
The examples given are hypothetical and for illustrative purposes only.
