What Does the IRS Consider Reasonable Compensation?

“Reasonable compensation” is the amount paid by a closely held corporation to a shareholder-employee that is justifiable for the services provided. The Internal Revenue Service (IRS) scrutinizes these payments because their characterization as salary versus a dividend or distribution has significant tax implications for the company. This often becomes a point of contention during audits, as the definition of “reasonable” is subjective. The final determination depends heavily on the specific facts and circumstances of the business and the employee.

The S-Corp and C-Corp Compensation Dilemma

The structure of a business entity creates different tax incentives, leading to two distinct compensation challenges with the IRS for S-corporations and C-corporations.

S-Corporations: The Low-Salary Problem

S-corporation owners may be tempted to pay themselves an artificially low salary because of how profits are taxed. An owner’s salary is subject to federal payroll taxes, including Social Security and Medicare. For 2025, the Social Security tax applies to the first $174,900 of wages, while Medicare tax applies to all wages.

Any remaining company profit can be passed to the owner as a distribution, which is not subject to these payroll taxes. This creates a motive to minimize salary and maximize distributions. Consequently, the agency ensures that S-corp owners who provide significant services receive a salary that reasonably reflects their contribution before any distributions are taken.

C-Corporations: The High-Salary Problem

C-corporations face the opposite issue, known as the “high-salary problem,” which arises from double taxation. The corporation first pays tax on its net income. When it distributes after-tax profits as dividends, shareholders pay personal income tax on that income.

To mitigate this, a C-corp owner might take an excessively high salary. Salaries are a deductible business expense that reduces the company’s taxable income. By inflating their salary, the owner can pull money out of the business while generating a corporate tax deduction. The IRS scrutinizes high salaries to determine if they are a “disguised dividend” intended to sidestep corporate-level taxes.

Key Factors in the IRS Analysis

When the IRS evaluates whether compensation is reasonable, agents and tax courts refer to a collection of factors established through legal precedent. These factors include:

• Employee Qualifications: The individual’s experience, formal training, and specific skills as they relate to their duties.
• Nature of Work: The complexity of duties, level of authority, and scope of work performed. An owner working 60 hours a week with extensive management responsibilities warrants higher compensation than one with a limited, part-time role.
• Business Size and Complexity: A larger, more intricate operation with multiple divisions or locations can justify a higher executive salary than a small, simple business. The IRS also compares the compensation to the company’s gross and net income.
• Company-Wide Compensation Policy: The IRS examines the company’s policy for all employees. A consistent approach to setting pay for non-owners can lend credibility to the owner’s salary.
• Comparable Pay: The agency looks at what similar businesses in the same industry and geographic area pay for similar services to create an external benchmark.
• Financial Health and Economy: A highly profitable company can more easily justify a large salary, while paying a high salary during an economic downturn could be viewed as unreasonable.

Methods for Calculating Reasonable Compensation

Business owners can use established methods to calculate a salary that aligns with IRS expectations. These approaches provide a logical basis for the compensation amount, making it easier to defend if challenged.

The most common method is the market approach, which involves researching compensation data for similar positions in comparable companies. This means looking at salary surveys and industry reports from sources like the Bureau of Labor Statistics or private data firms to find a salary range for a similar role.

Another technique is the cost approach. The business owner calculates what it would cost to hire a non-owner employee to perform the same duties. This requires a detailed job description for the shareholder-employee’s role and an honest assessment of the market rate to fill that position. This method effectively separates the owner’s value as an employee from their role as an investor.

A less common method is the income approach, which links compensation directly to the profit the employee generates. It is most applicable where an individual’s contribution to revenue is easily trackable, such as in sales-driven roles. This can provide strong justification for a high salary if the employee is a significant driver of the company’s success.

Tax Consequences of Unreasonable Compensation

If the IRS determines that compensation is unreasonable, the financial consequences can be significant. The agency will reclassify the payments, leading to back taxes, interest, and penalties for the company and the individual. The adjustments depend on whether the salary was deemed too low or too high.

S-Corporations: Salary Too Low

If an S-corporation owner’s salary is found to be unreasonably low, the IRS will recharacterize a portion of their profit distributions as wages. This adjustment triggers liability for the payroll taxes that were avoided. The company and the employee will each be responsible for their share of back Social Security and Medicare taxes on the reclassified amount. The company will also be liable for federal and state unemployment taxes on the new wages, in addition to interest charges and potential penalties.

C-Corporations: Salary Too High

For a C-corporation with an unreasonably high salary, the IRS will reclassify the excessive portion as a dividend. Because this amount is no longer a salary, the corporation loses the business expense deduction for that payment. This increases the corporation’s taxable income. The IRS will also assess interest on the underpayment and may apply accuracy-related penalties.

Documenting Your Compensation Decision

Proving that compensation is reasonable is much easier when the decision-making process is documented. This documentation should explain the “how” and “why” behind the salary figure. Important records include:

• Corporate Meeting Minutes: The board of directors should formally meet to approve the shareholder-employee’s compensation. The minutes should detail the factors considered, such as duties, company performance, and market data reviewed.
• A Formal Compensation Policy: This policy should outline the methodology the company uses to set pay for all employees. Determining the owner’s salary according to this policy adds credibility.
• Source Materials: Retain copies of any salary surveys, industry reports, or data from the Bureau of Labor Statistics that were used to benchmark the compensation.
• An Employment Agreement: A formal agreement between the corporation and the shareholder-employee should define the employee’s title, duties, and compensation. It serves as a contractual basis for the payments, distinguishing them from arbitrary profit distributions.