Infrequently, I like to post things I’ve heard from new clients, about what their prior tax preparer or accountant said about certain things, or mistakes the prior person made.
I usually have a “but by the grace of God go I” attitude on these things, because I’ve made plenty of mistakes myself, and if someone was to take a microscope to everything I’ve ever said and done for my clients, one could fill many blog posts making fun of me.
(To be fair, I do write on this blog about the mistakes and dumb things I’ve done.)
But sometimes, the things the prior accountant said are so detached from reality that I have to call attention to it. This is one of those cases.
S-corporation reasonable compensation is one of the most misunderstood concepts in tax law. And that’s saying something, considering how mind-numbing U.S. tax laws are.
This is something I heard from a client, regarding what their prior accountant had said about reasonable compensation for an S-corp owner: “the IRS formula is 25% of your gross income should be your salary.”
Whose “Formula” is This?
First of all, no such IRS “formula” exists. My guess is, 25% is the accountant’s opinion of what a safe amount of salary would be.
The law says the corporation must pay a “reasonable” salary to the owner if the owner provides services to the business. The definition of “reasonable” will vary depending on the type of business and the type of services provided by the owner.
In some cases, you might be able to legitimately say it’s “X” percent of gross income.
For example, one of my clients works in sales. He owns his own sales company. He does have a few employees and contractors working for him, but he also does a lot of the sales himself. He pays himself a salary equal to a percentage of the corporation’s sales revenue. The percentage is based on the industry standard for commissions in his field, which we’ve documented in case it ever gets questioned.
The “percentage” method doesn’t always work, though. You really have to look at the industry, the nature of the work, and the total amount of income being generated.