Gauging the Reasonableness of Owners’ Compensation Deductions

When you own and operate a corporation, whether a C corporation or an S corporation, paying yourself owner’s compensation is not just a business strategy: it’s a tax-compliance necessity. But what counts as reasonable compensation, and how can you justify it if questioned by the IRS? This guide covers when compensation is deductible, what reasonable means, and how to document and support owner pay to satisfy tax requirements.

Why Reasonable Compensation Matters

For owner-employees of corporations, compensation treated as wages salary is deductible under Internal Revenue Code § 162(a) if it qualifies as an ordinary and necessary business expense.
For S Corporation owners especially, the IRS mandates that shareholder-employees who perform meaningful services must receive a “reasonable” wage before taking profits as distributions otherwise the IRS may recharacterize distributions as wages, triggering back payroll taxes, interest, and penalties.
C Corporation owners overpaying yourself may also backfire; the IRS could recast part of the pay as nondeductible dividends.

In Short: setting owner compensation rights helps you avoid audits, tax-reclassification, and ensures deductions remain valid.

How the IRS Defines Reasonable Compensation

According to IRS guidance, reasonable compensation is generally defined as “the amount that would ordinarily be paid for like services by like enterprises under like circumstances.”

To evaluate reasonableness, the IRS looks at a range of factors, not a single formula. Key factors typically include:

The owner’s duties, responsibilities, and roles such as CEO, operations manager, sales, oversight
The time and effort the owner devotes to the business full-time vs. part-time, hands-on vs. passive
The owner’s skills, training, and experience
Comparable compensation in the same industry and geographic region for similar roles
The size, complexity, and profitability of the business including gross and net income, number of employees, capital investment
Compensation paid to non-owner employees for similar work and historical pay structure within the company.

How to Determine & Support Reasonable Owner Compensation

Here’s a practical approach to set, document, and justify owner compensation effectively:

List and define all owner responsibilities to compile a detailed job description: operations, management, sales, oversight, technical work, administration, etc.
Estimate time commitment what portion of time does the owner spend on business vs. other ventures or passive roles?
Research comparable market salaries use data from salary surveys, industry reports, regional benchmarks (e.g. via labor statistics or compensation databases).
Adjust for business size and profitability, a solo-owner consulting firm should expect different pay than a multi-employee manufacturing business, even if roles are similar.
Document the determination to keep formal records: board minutes or resolutions approving owner compensation; internal memos; compensation-study results; comparable data; job descriptions.
Review annually as earnings, duties, or workload shift, and reevaluate compensation to ensure it remains appropriate.

Following this approach helps create an objective, defendable record for the best protection in case of IRS scrutiny.

When Owner Compensation Is or Isn’t Deductible

If the owner's compensation qualifies as reasonable compensation for services and is structured as wages, it is deductible under IRC § 162(a) as a business expense.
When pay is too high and IRS deems it excessive relative to services, the excess may be disallowed and treated as nondeductible dividend or shareholder distribution.
If pay is too low, especially in an S-Corp with heavy distributions, the IRS may reclassify distributions as wages, making them subject to payroll taxes plus penalties.

Thus, the deductibility of owner compensation depends heavily on how well you document, justify, and support the amount.

Doing It Right

Setting out owner compensation isn’t just about minimizing taxes; it’s about balancing fairness, business needs, and compliance. Reasonable pay reflects the actual value of services provided, consistent with market standards and the business’s scale. Clear documentation and thoughtful, regular evaluation can help you strike the right balance: optimizing tax benefits while safeguarding against re-characterization, audit risk, and unexpected liabilities.

For more information about reasonable owners' compensation, contact a business valuation professional. He or she can help estimate total compensation levels, find objective market data and adjust deductions that are above or below market rates.

Sources:

Corporate Business Owners: Is Your Salary Reasonable For the IRS

Entity Type Matters When Evaluating Compensation

The IRS has published a guide titled, "Reasonable Compensation: Job Aid for IRS Valuation Professionals." IRS field agents use this guide when conducting audits to help determine what's reasonable and how to estimate an employee's total compensation package.

The IRS is on the lookout for C corporations that pay excessive salaries in place of dividends. This tactic lowers the overall taxes paid, because salaries are a tax-deductible expense and dividends aren't. Shareholder-employees of C corporations pay income tax on salaries at the personal level, but dividends are subject to double taxation (at the corporate level and at each owner's personal tax rate). If the IRS decides that a C corporation is overpaying owners, it may reclassify part of their salaries as dividends.

For S corporations, partnerships and other pass-through entities, the IRS looks for businesses that underpay salaries to minimize state and federal payroll taxes. Rather than pay salaries, pass-through entities are more likely to pay distributions to owners. That's because distributions are generally tax-fee to the extent that the owner has a positive tax basis in the company.