IRS always has a few "hot list" items that they focus on annually and Reasonable Compensation for S Corporation Shareholders is one that continues to be on the list. This is one of the "low hanging fruits" that is easy for IRS to detect and collect penalties on. With the large influx of trained IRS agents, we want to ensure that you are following the correct S Corporation guidelines and maintaining the ability to be audit-proof with IRS.
As a shareholder-employee of an S Corporation, meaning you are performing services for the company, you are required to pay yourself reasonable compensation if you are making distributions to yourself. If you're not making distributions, there is no requirement for reasonable compensation but future distributions from the corporation can be problematic. The term distributions refer to when a check is issued or bank transfer is processed to the shareholder-employee of a business and it is not processed through payroll. Another instance of a distribution is if the business pays for a personal expense of the shareholder-employee that would not be tax deductible to the business. You want to avoid paying personal shareholder expenses through the business. By doing so, you ensure that you do not pierce the corporate veil which protects shareholders from personal liability for the company's debts. The proper way to handle this situation is to make a direct payment to the shareholder-employee's account either through wages or a distribution and for them handle their personal expenses personally.
What does the term reasonable compensation mean though? Reasonable compensation in its simplest terms refers to the dollar amount you need to pay someone to replace yourself for the tasks you perform. You need to consider your demographic area, the tasks you perform, how long it takes to complete the tasks, the complexity of the tasks and the quality by which the tasks are completed. The level of responsibility required, and the shareholders' prior salary history will also be reviewed. It is imperative to consider all factors to ensure that if audited, IRS will not determine that the officer was underpaid for the services they provided.
If IRS determines the shareholder employee was underpaid for their services, net income that was originally reported for the business or distributions made from the business could be recategorized as wages triggering payroll taxes, penalties and interest to be assessed. Additionally, the associated payroll tax returns associated with those periods could need to be amended. Another item to consider is if a shareholder leases real estate to the S Corporation. Rent would need to be at fair market value for similar properties in the area. If the rent is above FMV, IRS could elect to treat the excess as additional wages subject to overdue payroll taxes with penalties and interest. IRS could alternatively treat the excess rent as a disguised distribution or a contribution of capital, both of which would reduce expenses and increase the business income.