By Terri Brechter, CPA

If you’re an S corporation owner, paying yourself a reasonable salary isn’t optional, it’s a legal requirement. The IRS requires shareholder-employees who provide services to their S corporation to pay themselves reasonable compensation before taking distributions. Failing to do so can lead to serious consequences that far outweigh any short-term tax savings.

Why “Reasonable Compensation” Matters

The IRS scrutinizes S corporations that report little or no wages to shareholders while showing large distributions or profits. Their position is simple:

If you’re performing substantial services for your business, part of the income must be classified as wages subject to payroll taxes (Social Security and Medicare).

The Risks of Noncompliance

Failing to meet reasonable compensation standards can result in:

• • IRS Reclassification: The IRS may reclassify distributions as wages, leading to back taxes, penalties, and interest.
  • Employment Tax Assessments: You could be liable for unpaid FICA taxes plus late deposit penalties.
  • Audit Exposure: The IRS continues to flag low officer compensation as a high-risk issue in S corporation examinations.

Potential Loss of S Corp Status: In extreme cases, repeated noncompliance can threaten your S corporation election.

Example: The Cost of Cutting Corners

Imagine an S corporation pays the shareholder only $25,000 in wages. During an IRS review, the Service determines that a reasonable salary for that industry and role should be $100,000.

The IRS reclassifies $75,000 of distributions as wages, adds payroll taxes, interest, and penalties, turning a potential tax-saving strategy into a costly mistake.

How to Stay Compliant

Determining what’s “reasonable” isn’t guesswork, it depends on:

• • The type of work you perform
  • Industry standards and regional pay data
  • Time devoted to the business
  • Documenting your analysis is key to defending your position if ever questioned.

We Can Help

abip now offers a Reasonable Compensation Analysis service to help you:

• • Establish defensible, IRS-compliant compensation levels
  • Benchmark your pay using reliable industry data
  • Reduce audit risk and avoid unexpected payroll tax assessments

By proactively reviewing your compensation now, you can strengthen compliance and keep more of your hard-earned money working for you, not the IRS.

Contact abip today to schedule your Reasonable Compensation Analysis and ensure your S corporation is on solid ground for 2025 and beyond.