Are You Paying Yourself Reasonably? IRS Rules for C Corp and S Corp Owner Reasonable Compensation

If you own a C corporation or S corporation, the salary you pay yourself matters more than you might think. The IRS scrutinizes owner compensation, and getting it wrong can lead to disallowed deductions, reclassified payments, penalties, back taxes, and interest.

Determining what the IRS considers “reasonable compensation” is critical for corporate business owners. By proactively following specific steps, you can help ensure your compensation withstands IRS scrutiny.

Different Strategies for C Corps and S Corps Create Different Risks

C-corp owners often pay themselves larger salaries because those salaries are tax-deductible business expenses that reduce the corporation’s taxable income. Higher salaries mean lower corporate taxes, which makes this an attractive strategy.

However, if your salary is excessive compared to the work you actually perform, the IRS may reclassify some of it as nondeductible dividends. That reclassification results in higher taxes and potential penalties.

S corp owners typically take the opposite approach, taking a smaller salary while receiving larger distributions. This strategy works because S corp profits flow through to owners’ personal tax returns, and distributions aren’t subject to payroll taxes. By minimizing salary and maximizing distributions, S corporation owners aim to reduce their payroll tax burden.

But if the IRS determines your salary is unreasonably low, it may reclassify some of those distributions as wages and impose back payroll taxes and penalties.

The IRS closely monitors both strategies because they can be used to avoid taxes. That’s why C corporation and S corporation owners must set compensation that reflects fair market value for the work they perform.

What the IRS Considers Reasonable Compensation

The IRS defines reasonable compensation as the amount that would ordinarily be paid for similar services by similar enterprises under similar circumstances. Put simply, the IRS wants to see that what you pay yourself aligns with what you’d pay someone else doing the same job.

When evaluating whether your compensation is reasonable, the IRS examines several factors:

• Your duties and responsibilities
• Your training and experience
• The time and effort you devote to the business
• Comparable salaries for similar positions in the same industry and region
• The gross and net income of your business

You should regularly review these factors to ensure you can defend your pay levels if challenged.

How to Establish and Document Reasonable Compensation

Taking these steps helps you establish compensation that can withstand IRS scrutiny:

Conduct market research 

Gather data on what other companies pay for similar roles. Salary surveys, industry reports, and compensation databases, such as those from the U.S. Bureau of Labor Statistics, provide valuable benchmarks. Document your findings and keep them on file. This demonstrates that your compensation decisions were based on objective data rather than personal preference.

Keep detailed job descriptions 

A well-written job description detailing your duties and responsibilities helps justify your salary. Outline all the roles you perform, whether that’s CEO-level strategic leadership, day-to-day operations management, or specialized technical work. The more responsibilities you handle, the stronger your case for higher compensation.

Maintain formal records

Hold regular board meetings and formally approve compensation decisions in the meeting minutes. This adds an essential layer of corporate governance and shows the IRS that compensation was reviewed and approved through an appropriate process.

Document annual reviews

Perform an annual compensation review and adjust your salary to reflect changes in your business’s profitability, your workload, or industry trends. Keep records of these reviews and the rationale behind any changes.

An Ongoing Process, Not a One-Time Decision

Determining reasonable compensation isn’t something you do once and forget about. It requires ongoing attention as your business evolves and market conditions change.

CJG Partners helps corporate business owners benchmark compensation, draft required documentation, and remain compliant with tax laws. This approach not only strengthens your position against IRS scrutiny but also supports your broader business strategy.

Need guidance on setting or reviewing your compensation structure? Contact CJG Partners to discuss how we can help you navigate this critical tax planning issue.