When you incorporate your business, you create a new separate entity, and in the eyes of the IRS, you become an employee of the corporation. And this move means you must go on payroll and have all corresponding payroll taxes withheld and matched by the employer.

The owner of the S corporation is also allowed to take distributions of current profit. The distributions are subject only to regular income tax. Unlike salaries and wages, distributions are not subject to withholding or employer paid payroll taxes for the IRS or the state.

Taking distributions is therefore a more attractive, less expensive option than taking a paycheck.

However, the IRS wants its fair share of payroll taxes, and therefore requires that shareholders take adequate compensation over distributions.

About five years ago, the IRS created an audit project aimed at attorneys who were incorporated as Sub S corporations. It found that many attorneys were violating the reasonable compensation concept. In one instance, an attorney’s salary was $30,000 for the year, but his distributions totaled almost $400,000. The IRS reclassified much of the distributions as wages and charged the corporation additional payroll taxes, penalties and interest.

So what is reasonable compensation? How do you determine if you are allocating the funds you receive from your corporation in compliance with IRS requirements? There is no place in the tax code that makes a specific requirement, such as, if you own a shoe store, you must pay yourself wages of $50,000 per year. Instead, the IRS states, “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.” Pretty vague and subjective. Essentially, the IRS judges reasonable compensation on a case by case basis.

These are some of the factors they consider:

1. Use a wage a shareholder would likely earn on the open market. So in the case of the attorney, paying himself wages of $30,000 and taking distributions of $400,000, the IRS concludes that the attorney would never accept a job in his field at a salary of $30,000.

2. The amount of time spent engaged in corporate activities. If you own the corporation and are semi-retired working only 15 hours per week, you may factor in fair pay for part time work and likely take larger distributions.

3. The amount of work and profit generated by the owner/shareholder versus other employees. If the majority of the workload is handled by the shareholder and let’s say for example, there is only one non-shareholder employee who works part time providing administrative support, the compensation provided to the shareholder/owner will be titled largely to wages rather than distributions for the IRS to consider it reasonable.

In order to minimize the risk of understating or possibly overstating reasonable compensation, Paul Hamann, founder of RCReports based in Denver, created an online software tool used by tax and legal professionals to guide corporate principals in determining reasonable compensation based on the attributes of their work and that of their firm.

An interview process guides the user through a description of duties and activities then creates a report with the data and arrives at a reasonable compensation figure for each principal in the firm.
The testimonial page is impressive and includes an endorsement from a former IRS agent.
The IRS may or may not agree with the results provided by this software, but doing your research and being informed can help lower your chances of raising red flags at the IRS.

Bonnie Lee is an enrolled agent admitted to practice and representing taxpayers in all 50 states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, Calif., and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Her new e-book Taxpertise for the Creative Mind Murder, Mayem, Romance, Comedy and Tax Tips for Artists of all Kinds is available at all major booksellers. Follow Bonnie Lee on Twitter and on Facebook.