Reasonable Compensation Analysis
What is Reasonable Compensation?
The IRS requires S corporations to pay their owner-shareholder employees reasonable compensation for services performed
Thank you for reading this post, don't forget to subscribe!
- It's
- The
- Law
Reasonable Compensation
The IRS defines reasonable compensation as the amount you would pay someone else with skills and experience to do the same work at a similar business under similar circumstances.
Simply Put
The owner of the business must take a “reasonable W-2 salary”. They must pay taxes on these wages in the same manner as other employees.
Why Is Reasonable Compensation Compliance Important?
Owners who avoid payroll taxes by underpaying wages can face significant IRS penalties, including monetary fines, interest, tax liens, civil penalties, and possible criminal prosecution with imprisonment for willful violations.
Failure to deposit penalties: These range from 2% to 15% of the unpaid payroll taxes, increasing with the length of the delay.
Interest charges: The IRS imposes interest rates (typically 3% – 6%) in addition to penalties until the tax is paid.
Trust Fund Recovery Penalty (TFRP): Individuals responsible (including owners) for willfully failing to collect and remit payroll taxes may face this penalty, which can be up to 100% of the taxes due.
Tax liens: The IRS may claim a legal right to the business's property to secure payment for the unpaid taxes.
Criminal charges: Willfully evading payroll taxes can result in criminal prosecution, fines up to $10,000 and up to five years imprisonment for each offense.
The IRS may hold any individual with authority over payroll tax decisions, such as owners, officers, or accountants – personally liable for unpaid taxes and penalties. Payroll tax penalties are not deductible as business expenses, so these costs add direct financial burden to the owner and the business.
Type your paragraph here
Add Your Heading Text Helll
Add Your Heading Text Here
Add Your Heading Text Here
Tuesday Takes the Guesswork out of Reasonable Compensation
We leverage advanced AI-powered software to conduct a thorough reasonable compensation analysis using one of three IRS approved approaches and methodologies. You’ll receive a legally defensible report that not only details your reasonable compensation figure, but also explains the methodology used and includes all supporting documentation.
We go beyond just the numbers. Our team walks you through the findings, explains how they impact your tax strategy, and help you adjust payroll or distributions to stay compliant with IRS regulations. This proactive approach reduces your audit risk, ensures your salary aligns with industry standards, and gives you the documentation you need to confidently defend your position if ever challenged.
Most S Corp owners have never run a Reasonable Compensation analysis and it's costing them.
Calculating Reasonable Compensation?
The IRS defines three approved approaches to calculate Reasonable Compensation: the Cost Approach, Market Approach, and Income Approach. Each approach is useful in different situations and your accounting professional can help determine the appropriate approach to use based on your business.
The Cost Approach
AKA the many hats approach is the most common way to determine reasonable compensation. It calculates a reasonable compensation by determing what the replacement cost for each service a shareholder provides their business. This approach is useful for IRS compliance, litigation, and when industry benchmarks alone don't capture the breadth of the owner's responsibilities.
The Market Approach
AKA the industry standard approach compares the business owner's compensation of a CEO or General Operations Manager within an industry, location, number of employees, profit, and proficiency level. This approach is typically used at medium to large sized companies where the owner is primarily managing the company (not working within the company).
The Income Approach
AKA the independent investors approach evaluates if the compensation allows investors to receive a reasonable return on their investment. This approach is typically used when comparability data is unavailable, and works best when the fair market value of the company can be established for each year under review.