Ask The Experts: Determining Reasonable Salaries

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Ask The Experts: Determining Reasonable Salaries

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My wife and I own a limited liability corporation. We just elected to be treated as an s corporation. We are trying to determine salary levels, and I read something about how the owner’s salary must be greater than employee’s for s corporations to minimize the chance of an IRS audit. What criteria should we use to establish our salaries.

A: The key for the s corporation and the audit issues are not that an owner’s salary must be higher than an employee or any other ratio type analysis but only that the wages be “reasonable” in connection with the services provided. The underlying economics of the situation will always be the key factor in the reasonableness of the wage payments.

When we talk about reasonable compensation, most of us think of the big New York bankers or investment brokers and we talk about how much they make and think that it is unreasonable because the wages are so high. The s corporation issue is the reverse. The concern in the eyes of the IRS is that the wages are too low and therefore intentionally avoiding payroll taxes, FICA, Medicare, etc.

You should find some third-party support for the wages you pay yourself for the work you and your wife do. For example, is that an hourly wage that is common for people who do what you do?  Is there a trade association or membership for your industry that does a salary survey of your type of job? Are there other people in other companies doing what you do and, if so, what do they earn? Providing some third-party support for the wage you choose is the key to answering the IRS question if they ever actually ask it of you. 

Keep in mind that there is no process or decision or safe harbor that will prevent or even materially decrease your chances of being audited. So concentrate on the underlying economics of your situation, always consider the support for “reasonable” salaries, document your decisions, and then just be successful and let everything else take care of itself.

Keith Hall, NASE Tax Expert

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