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Determining reasonable compensation for employee-shareholders in S or C corporations is important to avoid IRS audits. Companies should establish policies and consider factors such as education and experience levels, hours worked, and industry standards to set salaries. Unreasonable compensation, such as zero pay or excessively high wages, can trigger IRS problems.
Many people who work for an S or C corporation, and are also shareholders, have a hard time determining how much compensation to give them or what amount would be acceptable as reasonable compensation. As a company, this is an important decision to make because it will affect taxes for both the company and the employees. The Internal Revenue Service (IRS) frequently audits companies in order to verify the accuracy of employee and shareholder wages. For a business, an IRS audit is not something they want to go through, so they should take care to do proper research and maintain an accurate paper trail in determining reasonable employee-shareholder compensation.
It may seem like a good idea for a company to create a very low salary for its employee shareholders because it will reduce the amount of payroll taxes the company will have to pay during the year. Some companies also try to pay their shareholders excessively high wages to increase business expenses and reduce the profit that the business or shareholder has to pay on income taxes. This will certainly save the company and/or shareholders money, but it will also be a red flag for the IRS and, if found to be inaccurate, cost the company more money in the end. It would be best for a company to create a system that it can use to determine reasonable compensation for its employee shareholders.
One of the best ways for a company to determine reasonable compensation for its employees is to establish a policy that sets specific standards. This will help if they are ever faced with an IRS audit. Keep in mind that compensation levels don’t have to be very high, just reasonable. Some factors a company should consider when setting salary levels are the average wages for similar positions in other businesses, hours worked, the employee’s education and experience level, and how many years they have worked for the company. When setting salary policies, companies should create wide salary ranges for different positions, giving them more flexibility to work with.
An unreasonable compensation that would cause a red flag for an IRS audit would be zero amounts of dollars paid, or wages that would fall below the minimum wage. This could prove to be a financial boon to the company, but it would greatly increase the risk of IRS problems. Reasonable compensation that falls in the middle bracket of an acceptable pay scale would be a better solution. A million dollars can also be considered unreasonable if other people in the same field are being paid substantially less. Find a broad median range of salaries for the given position and choose the high, or low, range for the salary in question that will deliver the best results for the company’s financial statements.
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