Kelly Bullis: ‘Reasonable compensation’ for Sub-S owners

You just gotta love the English language. We throw around a lot of words that can have different meanings. Take “reasonable” as an example. Webster’s dictionary says it means “much as is appropriate or fair; moderate; sensible.” The IRS says that means “what you would do to an unrelated third party.” (With regards to buying something, paying a fee for a service, etc.)

A little background on today’s topic. Owners of Sub-S corporations (which could be an LLC which has elected to be taxed as a Sub-S) are required by the IRS to pay themselves a “reasonable compensation.” Their reasoning is because Sub-S income is not subject to self-employment tax.

The number one way for a Sub-S owner to pay lower taxes is to set the right salary they pay themselves. They need to find the sweet spot, which is an amount low enough to save significantly on payroll taxes but high enough to satisfy the IRS and avoid the risk of an audit.

If a Sub-S owner doesn’t pay themselves a “reasonable compensation” for the services they perform on behalf of their Sub-S business, they can unfairly reduce the self-employment taxes they should have paid, and until the end of 2025, they get to deduct up to 20% of their Sub-S business profits from taxable income. (By paying themselves a smaller compensation, it leaves a larger business profit that is subject to that 20% reduction in taxable income.)

Given the fact the IRS just can’t stand anybody trying to arrange their affairs to reduce the amount of taxes they pay (by reducing the taxable compensation they pay themselves), the IRS has come out with some guidelines for computing what is “reasonable compensation.”

A basic rule the IRS likes to point to is “What would you pay somebody else to do your job?” On the surface, that can sound simple and fair. In reality, what you decide to pay somebody is not so simple. What is their experience level? What are other competitors paying for similar services? What is the regional adjustment (up or down) to commonly established pay structures for similar services.

If you decide that the range of potential salary you would pay for somebody doing your job might be a low of $40,000 to a high of $70,000. The big question is, “What is to prevent you from paying yourself the low end of that range?” The IRS doesn’t expect you to pay yourself only the highest possible salary, they do want you to be “reasonable” in going about determining what that amount is. It is suggested that you document your efforts to discover your “reasonable compensation.”

If paying yourself a “reasonable salary” causes your business to have a taxable loss, then you can reduce your salary until the business breaks even.

There is an old saying, “Pigs get fat, hogs get slaughtered, so don’t be a hog.” I think that applies to this situation.

Have you heard? Psalm 65:13 says, “The pastures are covered with flocks. The valleys also are clothed with grain. They shout for joy! They also sing.”

Kelly Bullis is a Certified Public Accountant in Carson City. Contact him at 775-882-4459. On the web at BullisAndCo.com. Also on Facebook.