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Reasonable compensation is the salary an unrelated employer would pay for the same work — what the IRS expects an S-Corporation owner-operator to take through payroll before drawing the rest as distributions. For active owners in service businesses, reasonable compensation is rarely below 40-60% of net profit. Lowballing the salary triggers IRS reclassification of distributions as wages, with back payroll tax (employer + employee FICA + Medicare = ~15.3% of the reclassified amount), penalties, and interest.
The IRS uses several factors to evaluate reasonable compensation: training and experience, duties and responsibilities, time devoted to the business, comparable salaries paid by similar businesses, dividend history, salaries versus distributions, formal pay arrangements, and the use of any non-shareholder employees. Documentation of these factors strengthens the position if challenged.
Industries where reasonable compensation runs higher: medicine, law, consulting, accounting, real estate brokerage. Industries where lower percentages can defend: capital-intensive businesses where return on equity is part of the business model, businesses with substantial non-owner workforces.
The defense is almost always documentation. Comparable-salary surveys, time studies, and payroll-versus-distribution allocations should be in writing at the time the salary is set, not reconstructed during an audit.
This answer is general legal information, not specific legal advice. Pereira & Associates can review your particular facts in the free consultation. Schedule one →
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