Reasonable Compensation is defined by the IRS as: “The value that would ordinarily be paid for like services by like enterprises under like circumstances.” or the hypothetical “Replacement Cost” of the shareholder-employee.

Reasonable Compensation is derived from the value of the services provided, not the profit or loss of the business. While Reasonable Compensation has nothing to do with Profit and Loss, it does relate to Distributions. Why? Because the IRS guidelines for Reasonable Compensation state: The amount of reasonable compensation will never exceed the amounts received by the shareholder either directly or indirectly. It does not mention profit or loss at all but instead talks about ‘amounts received’ by the shareholder. It does not matter if the company is making or losing money; what matters is whether or not the S Corp owner is taking money (e.g. a distribution or other items of value) out of the S Corp.

Depending on the company’s financial condition and business strategy, a shareholder-employee may be able to take Reasonable Compensation plus a distribution, just Reasonable Compensation, or neither. What the shareholder-employee can’t do take a distribution instead of Reasonable Compensation.

This excerpts above create by far the most succinct explanation I’ve seen so far of how reasonable compensation is supposed to work. The original blog post goes on to offer a bunch of excellent example scenarios to help illustrate the concept.

I subscribe to RCReports.com (the author of the blog and these excerpts) and advise my S-Corp clients to do a reasonable compensation interview with me (using the RC Reports tools) at least every three years; though preferably every-other year. And if their circumstances change significantly — hiring staff or investing in equipment, especially if it allows them to cut back on their own hours — then we do a re-evaluation mid-year. As the blog also points out:

Anything that compensates the S Corp owner can be re-characterized as wages, including personal expenses paid by the S Corp or loans to the S Corp owner. At the end of the day a distribution of any kind triggers the requirement to pay Reasonable Compensation for services provided. Best practice is to know what the value of those services are and pay that amount in Reasonable Compensation before taking a post-wages distribution of any kind.

With the new Sec 199A Qualified Business Income Deduction, the issue of reasonable compensation is bigger and more important than it’s ever been before — make sure you (or your clients) have a credible basis for this amount, and for goodness sake, please don’t take distributions until you’re sure you can pay out the full annual amount of salary or wages due to you.

RC Reports is offering an upcoming free continuing education class on Reasonable Compensation for S-Corp Shareholder-Employees that I encourage all tax professionals and S-Corp owners to attend.

For the record — I receive no discounts or commissions for their service; I’m simply promoting it because I love their continuing education, blog posts and products.

Source: What if an S Corp Owner can’t afford to pay Reasonable Compensation? – RCReports