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S-Corporations and Reasonable Compensation

It is a requirement for S-corporation shareholders to pay themselves reasonable compensation for the work they do in the company.  This reasonable compensation is subject to payroll tax. To save on payroll tax, it has long been a strategy for shareholders to reduce their compensation and to increase their distributions.   Because of this practice the IRS tends to scrutinize the amount shareholders take as compensation to determine if it is reasonable under the circumstances.   They compare compensation paid to others in similar roles by industry to conclude if a shareholder was underpaid.  If the IRS adjusts the ratio of compensation to distributions, a company may find themselves being subject to penalties for failure to withhold and file payroll taxes.  If an S-corporation is setup to make distributions to shareholders based on their ownership percentage, and the IRS adjusts the amount of distributions, a company may find their distribution becoming disproportionate.  In very extreme cases this could even cost the company their S-corporation status. However, S-corporations can detain IRS scrutiny concerning compensation with a little forethought.  Annual compensation reviews can at least force the shareholders to consider this issue, and make changes if deemed appropriate.  IRS scrutiny is rarely desirable, so plan ahead to avoid the headache and make sure to consider the advice of your tax advisor when determining reasonable compensation

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