13 Ways to Help Ensure Your Business Compensation is Reasonable

One of the responsibilities that business owners have is to ensure compliance with tax laws. Thankfully, your CPA helps with this complex task, but there are some aspects of being a business owner that must be decided as an owner. One of those is compensation. While your CPA can help to guide you, you must determine how much to pay yourself and your employees. More importantly, determining reasonable compensation isn’t only an internal decision; it’s a crucial component of legal compliance. And it has ramifications as far as ensuring your company has the financial stability to be economically viable far into the future. Missteps in setting compensation can lead to audits, penalties, or even conflicts within the company. Here are X ways to help ensure your business compensation is reasonable:

1. Know What Reasonable Compensation Means

Reasonable compensation isn’t just a random term. It’s an important term that the IRS uses when it scrutinizes compensation for S corporation shareholders and other business owners, especially in cases where salaries may appear artificially low to avoid payroll taxes. It’s defined as the compensation that would be typically paid to anyone else who possesses similar skills, education, background and other qualifications, and who holds a comparable job title in the same industry or region or both. 

Just as an example, if you pay yourself as the owner and chief structural engineer of a structural engineering company only $20,000, that’s not reasonable compensation. Most others in that industry and with that title would get at least twice that and probably three times that amount. The IRS would be suspicious of this, with the suspicion being that you’re trying to pay less in payroll taxes and personal income tax with this strategy. 

2. Research the Industry Standards

Spend some time online researching data on salary ranges. A good source to start with is the Bureau of Labor Statistics. You can also look at industry reports, which often reveal key personnel salaries. There are also 3rd party companies that offer this service, where you can enter details about your industry, company size, location and levels of expertise and get back a report about reasonable compensation ranges that you can use to make informed decisions about your own compensation decisions.

3. Record the Role’s Responsibilities

Outline the specific duties and responsibilities of the position that you’re researching. A clear job description can help justify the compensation level by aligning it with the workload and expertise required. Documenting these details can also serve as evidence in case you do end up with an audit on your hands. One easy way to do this is to write up a job listing. Detail all the responsibilities that a new hire would be expected to fulfill. This process—even if you aren’t actually hiring at the moment—can help you to clarify your thoughts around the role of that position.

4. Weigh the Qualifications

Carefully evaluate the qualifications of the individual. Include job-specific experience that uniquely qualifies that person for the role. Advanced degrees, certifications, or a proven track record of success in similar positions can justify higher compensation, while a lack thereof can justify a lower compensation. Note your process of evaluation in writing so you don’t have to rely on memory should it be questioned at a later date.

5. Balance Salary and Distributions

For S corporations, balancing salary and shareholder distributions is particularly important. While distributions are not subject to payroll taxes, underpaying yourself in salary to maximize distributions can trigger IRS scrutiny. A reasonable salary should reflect the value of the work performed for the business.

6. Factor in Business Performance

Your business’s profitability can influence compensation levels. During high-profit years, it may be reasonable to offer bonuses or raises. Conversely, in lean years, adjustments to salary may be necessary to maintain financial stability.

7. Separate Personal Expenses from Compensation

It’s essential to distinguish between business compensation and personal benefits. Using company funds for personal expenses can lead to accusations of unreported income. Clearly define and document any perks or benefits provided.

8. Periodically Review Compensation Levels

Markets and business conditions change over time, so regularly reviewing and adjusting compensation is important. Conduct annual or biannual reviews to ensure pay remains competitive and reasonable according to market rates.

9. Avoid Excessive Compensation

While underpaying can be problematic, so can overpaying. Excessive compensation might raise red flags with tax authorities, particularly if it’s perceived as a way to divert profits for tax benefits. Keep salaries within justifiable limits based on the role and business performance.

10. Consider Non-Cash Compensation

In some cases, offering non-cash benefits such as stock options, profit sharing, or additional vacation time can complement cash salaries. These perks can enhance overall compensation while aligning with long-term business goals.

11. Conduct Peer Comparisons

Comparing your compensation to peers in similar businesses can provide a reality check. If your pay significantly deviates from the norm, it’s worth revisiting your structure to ensure it’s justified and reasonable.

12. Align with Shareholder Expectations

If your business has multiple owners, shareholders or other stakeholders, ensure that compensation aligns with agreed-upon expectations. Transparency in pay structures can help avoid conflicts and maintain trust among stakeholders.

13. Prepare for Audits

If the IRS or other authorities question your compensation, being prepared with documentation and justification can make all the difference. Having clear, well-documented reasoning behind your pay decisions demonstrates your commitment to compliance.

Ensuring reasonable business compensation is an ongoing process that requires diligence, research, and a clear understanding of legal and market standards. By following these steps, you can protect your business from financial and legal risks while maintaining fair and justifiable pay structures. If you’re uncertain about any aspect of compensation, consulting with experts can provide the clarity and support needed to navigate this critical area effectively.

by Kate Supino