This week we are looking at reasonable compensation, a legal necessity for anyone running a Corporation. Reasonable compensation is connected to one of the most fundamental parts of working for a company – getting paid – and yet it’s so widely misunderstood. When you form an Corporation, you create a separate, legal entity that ‘earns’ money. You then pull your wage from those earnings and pay whatever payroll taxes you owe.
In order to close a loophole wherein those running the corporation could ask for an extremely low salary, pay next to no payroll taxes, and then close the wage gap with distributions, the IRS requires that all corporate officers and executive be paid ‘reasonable compensation.’ But what constitutes reasonable compensation is a little more murky.
Who needs to be concerned with reasonable compensation?
Anyone that is runs, or helps run, a C-Corporation or S-Corporation must be reasonably compensated for their work.Now if an officer performs ‘no services or only minor services,’ they are not technically an employee. But for the most part, anyone involved with running the company has to earn a wage, and that wage has to be set at a level that pleases the IRS.
What are the rules for reasonable compensation?
This is where everything gets tricky. There are no hard and fast rules for reasonable compensation – the IRS doesn’t want to be involved in setting limits on executive pay. However, they do say that whatever you are payed should ‘commensurate with your duties.’ Most financial advisors and accountants believe the IRS looks at C-Corporations for overpayment and S-Corporations for underpayment.
So how do you determine what your own reasonable compensation is?
It is generally accepted that the IRS normally looks at what people in similar positions and areas are earning, and bases their expectation for reasonable compensation on those wages. So a small business owner in rural Kansas that recently incorporated his company shouldn’t be pulling the same wage as a New York-based executive of some multi-national firm. You should also factor in the time you spend running the company, how vital you are to the business’s success, and your career experience. If you truly want to be safe, meet with your accountant and ask them to help you with your wage.
Need help getting incorporated? Have any other questions about reasonable compensation? Give us a call at 1-877-692-6772!