Fact Checked

What Is Reasonable Compensation?

C. Daw
C. Daw

Many people who work for an S or C corporation, and are also shareholders, have a difficult time determining how much compensation to give them, or what amount would be acceptable as reasonable compensation. As a corporation, this is an important decision to make because it will affect the taxes for both the corporation and the employees. The Internal Revenue Service (IRS) frequently audits corporations in order to check the accuracy of the employee-shareholder salaries. For a business, an IRS audit is not something they want to go through so they should take care in doing proper research and keeping an accurate paper trail when determining the reasonable compensation for the employee-shareholders.

It may appear to be a good idea for a business to create a very low salary for their employee-shareholders because it will reduce the amount of payroll taxes that the business will need to pay throughout the year. Some corporations also try to pay their employees-share holders excessively high salaries in order to increase the business expenses and to reduce the profit the corporation or shareholder needs to pay on the income taxes. This will certainly save the corporation and/or shareholders money, but it will also be a red flag to the IRS and if found to be inaccurate it will cost the corporation more money in the end. It would be better for a business to create a system to use for determining reasonable compensation for their employee-shareholders.

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Businessman giving a thumbs-up

One of the best ways for a business to determine a reasonable compensation for their employees is to set up a policy that sets specific standards. This will help if they are ever faced with an audit from the IRS. Keep in mind that the compensation levels do not have to be very high, just reasonable. Some factors a corporation should take into account when setting the salary levels are the average salaries for similar positions at other businesses, hours worked, education and the experience level of the employee, and how many years they have worked for the company. When setting salary policies, corporations should create wide salary ranges for different positions, giving them more flexibility to work with.

Unreasonable compensation that would cause a red flag for an IRS audit would be a zero amount of dollars paid, or salaries that would fall below the minimum wage. This may prove to be a financial benefit to the corporation, but would greatly increase the risk of IRS troubles. A reasonable compensation that falls in the bottom bracket of an acceptable pay scale would be a better solution. One million dollars may also be considered unreasonable if other people in the same field are being paid substantially lower. Find a wide median range of salaries for the given position and choose the high end, or low end, for the salary in question that will provide the best results for the financial statements of the business.

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