What is reasonable compensation?

As the owner of an S Corporation or an LLC treated as an S Corporation, you are required to be a W-2 employee of the business. As a W-2 employee, the IRS says you need to take “reasonable compensation.” Any remaining profit taken out of the business can be classified as a “distribution.” 

These two concepts are important because they are taxed very differently: 

• Reasonable compensation is treated as any other W-2 wages and is subject to self-employment taxes, which includes Social Security at 12.4%, Medicare at 2.9%, and Federal and State unemployment taxes. At the federal level, this means a total tax of 15.3% before you pay income tax on your reasonable compensation.
• Distributions are treated as ordinary income in that they are taxed by the recipient’s individual tax rate but are not subject to the 15.3% self-employment tax. 

Let’s look at an example of how reasonable compensation and distributions can save you money as an S Corporation or an LLC treated as an S Corporation:  

Two child care providers, Adrianne and Jackie, made $50,000 each last year. Adrianne has a sole proprietorship and Jackie has an LLC treated as an S corporation. Both are in the 24% income tax bracket.  

Adrianne first has to pay 15.3% self-employment tax on the $50,000 she made, totaling $7,650. Because she is in the 24% tax bracket, she will also pay another $12,000 in taxes ($50,000 in income multiplied by 24%). In total, Adrianne will pay $19,650 in taxes, or 39.3% of the $50,000 she earned. 

Now, let’s take a look at Jackie. She takes half her income as her “reasonable compensation” and the remaining $25,000 as a distribution. The reasonable compensation is subject to 15.3% in self-employment taxes, for a total of $3,825 in taxes. The total income of $50,000 is then taxed as regular income in the 24% tax bracket for a total of $12,000. However, because only her reasonable compensation portion of her income is subject to self-employment tax, Jackie’s full tax bill is only $15,825, or 31.65% of her earnings. This is $3,825 less than Adrianne’s taxes. 

The IRS says that the owner of an S Corporation or an LLC that is treated as an S corporation must receive reasonable compensation. However, the IRS does not provide a specific way to figure out how much that should be. Instead, they suggest basing the amount on things like:

• The owner's skills and experience
• The owner's duties and responsibilities
• The time and effort the owner spends doing those duties
• The size and complexity of the business
• The pay given to other employees in similar jobs

In response to the lack of guidance, there are three methods that are typically used by small business owners. 

First is the percentage method. This method takes IRS audit history into account, which shows that about 30% to 50% of total compensation can be Reasonable Compensation. In our example above, Jackie could pay herself 30% to 50% of the $50,000 in W-2 income, so $15,000 to $25,000. 

However, while this percentage is reasonable, it is difficult to defend with the IRS. If you use the percentage method and are audited, it can be difficult to argue that your compensation is reflective of your work and role in the business when in actuality, it was determined based on a percentage of your total income. 

Second, is the similar job method. When opting for this method, you will look for job openings for similar positions to yours. These openings should match many of the tasks you perform, though they may not cover all of them. For example, a home-based provider might look at advertisements on Indeed or LinkedIn for child care educators or directors of small centers. Find at least 2-4 examples and keep a record of the listing in case the IRS asks. You will want to average the wages for each similar position or use the one that aligns most with the tasks you perform. Your remaining compensation would be taken as a distribution. You can also use Bureau of Labor Statistics data on average pay as well.  

For example, let’s say Jackie used this method and came up with an average salary of $26,000. This amount would become her W-2 pay and the remaining $24,000 of her annual compensation could be a distribution. 

Finally, there is the similar activities method. Using this approach, you will approximate the time you spend on various activities and tasks and determine a fair compensation for each. 

For example, let’s say Jackie determined that she spent:  

• 10% of her time managing staff;
• 10% doing bookkeeping and financials;
• 60% of her time in a classroom educator role; and
• 20% of her time doing support activities such as cleaning classrooms or re-filling supplies. 

She would then find similar positions and determine the pay for each job or use average pay listed by the Bureau of Labor Statistics. She would then determine a percentage of the pay for each job based on the amount of time she spends completing each task to make up her compensation. 

In this case, Jackie would use $29,700 as her reasonable compensation. 

Typically, it is recommended to use a combination of the Similar Job or Activity Method and the Percentage Method. By doing this, you will have a reasonable compensation that is grounded in real amounts, data, and the community you are a part of from the Similar Job or Activity Methods and a way to ensure that your determined pay makes sense based on the Percentage Method. 

Let’s use Jackie as an example again. She determined her Reasonable Compensation to be $26,000 through the Similar Job method. If her total compensation for the year is $50,000, her reasonable compensation is 52% of the total, so above the Percentage Method’s 30-50% range and a reasonable amount.  

Now, let’s say she receives a grant from the State and her compensation increases from $50,000 to $80,000. Now, her $26,000 is only 32% of her total compensation. In this case, she may want to consider giving herself a bonus as a W-2 employee or a raise since her compensation has significantly increased overall. 

Disclaimer 

 The information contained here is for educational purposes only and is not intended to constitute legal, tax, or financial advice.