Reasonable Compensation Doctrine
The IRS doctrine requiring S-corporation shareholder-employees to receive reasonable wages for services performed before taking distributions. Designed to prevent S-corp owners from avoiding employment taxes by characterizing compensation as distributions. Underpayment exposes the corporation and shareholder to reclassification, back payroll taxes, penalties, and interest.
The reasonable compensation doctrine requires S-corporation shareholder-employees to receive reasonable wages for services rendered to the corporation before taking distributions of corporate earnings. The doctrine is the IRS's principal enforcement mechanism against S-corp owners who attempt to avoid Social Security and Medicare taxes (FICA) by characterizing what should be wages as tax-favored distributions instead.
Why the doctrine exists
S-corporation income passes through to shareholders without being subject to self-employment tax (unlike a general partner's distributive share of partnership trade or business income, which is generally subject to SE tax whether or not distributed). Wages paid by an S-corp to a shareholder-employee are subject to FICA (15.3% combined employer/employee, with the Medicare portion uncapped). This creates a tax-arbitrage incentive for S-corp owners: minimize wages, maximize distributions. The reasonable compensation doctrine, combined with potential IRS reclassification authority, prevents the abuse.
Reasonable compensation factors
The IRS and courts apply a multi-factor test to determine reasonableness, including: (1) training and experience of the shareholder; (2) duties and responsibilities; (3) time and effort devoted to the business; (4) dividend history; (5) payments to non-shareholder employees in similar roles; (6) timing and manner of paying bonuses to key personnel; (7) what comparable businesses pay for similar services; (8) compensation agreements; (9) the use of a formula to determine compensation. Courts have relied on compensation surveys and expert testimony about comparable pay, as the court did in Watson.
IRS reclassification consequences
If the IRS determines that distributions paid in lieu of wages were unreasonable, it may reclassify those distributions as wages. The corporation owes back FICA (employer 7.65% plus shareholder 7.65%) plus FUTA, plus applicable penalties and interest. For multi-year audit periods, the cumulative exposure can dwarf any tax savings achieved by under-paying wages. The assessment period for the employment taxes is generally three years, with quarterly employment tax returns for a year treated as filed on April 15 of the following year. The six-year rule for substantial omissions applies to income, estate, gift and certain excise taxes, not to employment taxes.
Practical compensation analysis
Records that support a compensation determination can include: (1) external market data for the role and industry; (2) the shareholder-employee's specific duties documented in writing; (3) a formula or methodology applied consistently across years; (4) consideration of dividend history and corporation profitability; (5) board or written-consent documentation of the compensation decision.
For Texas S-corp owners, the reasonable compensation question becomes pointed at three moments: (1) at S-corp election, establishing initial wage levels; (2) during a profitable year when distributions are large relative to wages; (3) under IRS examination. A written annual compensation analysis kept with the corporate records gives the corporation contemporaneous support if the question is examined.
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