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Understanding the IRS Law of Reasonable Compensation — And How to Audit for Compliance
Reasonable compensation is a concept embedded in U.S. tax law that directly impacts how closely held corporations—especially S Corporations and C Corporations—pay their shareholder-employees. While the term may seem subjective, the IRS Law of Reasonable Compensation is a serious regulatory standard that carries significant tax and legal consequences if violated.
In this article, we will explore:
- What the IRS means by “reasonable compensation”
- Why it matters
- The legal and tax implications of non-compliance
- How companies can audit themselves to ensure compliance
What Is the IRS Law of Reasonable Compensation?
The IRS Law of Reasonable Compensation requires that individuals who provide services to a business—especially if they are owners or shareholders—be paid an amount that reflects the value of their work.
According to IRS guidelines:
“Reasonable compensation is the amount that would ordinarily be paid for like services by like enterprises under like circumstances.”
This law typically applies to:
- S Corporation shareholders who also work in the business
- C Corporation officers who might take dividends instead of salary
- Family-owned businesses where compensation could be manipulated to shift income or reduce taxes
Why It Matters
Reasonable compensation laws exist to prevent abuse of the tax code, especially in entities where the line between ownership and employment can blur.
Key tax implications:
- Underpayment of wages (e.g., in S Corps) can lead to payroll tax avoidance, since distributions to shareholders aren’t subject to Social Security and Medicare taxes.
- Overpayment of wages (e.g., in C Corps) can be used to deduct excessive compensation, thereby reducing taxable corporate income and improperly shifting funds.
If the IRS determines compensation is unreasonable, it can:
- Recharacterize distributions as wages (triggering retroactive payroll taxes, penalties, and interest)
- Deny tax deductions for excessive compensation
- Impose additional scrutiny on the business’s tax filings and governance
Key Factors the IRS Uses to Determine Reasonable Compensation
The IRS looks at multiple factors to determine what constitutes reasonable compensation, including:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Comparative compensation (industry, region, company size)
- Financial condition of the company
- Compensation agreements
- Use of bonuses and non-cash compensation
- Historical compensation patterns
The more documentation a company has to support these factors, the better its defense in the event of an IRS audit.
How to Audit for Reasonable Compensation Compliance
Conducting a reasonable compensation audit is a proactive way to ensure compliance, minimize audit risk, and establish defensible compensation practices.
Step 1: Identify All Key Individuals Receiving Compensation
Start by identifying:
- Shareholders of S or C Corporations who are also employees
- Officers, directors, or family members receiving salary or distributions
- High-compensated employees who are paid significantly more or less than peers
Step 2: Document Job Descriptions and Roles
For each person, create or update formal job descriptions that outline:
- Duties performed
- Time spent on each role
- Skills and experience required
- Decision-making authority
This forms the basis for benchmarking comparable roles.
Step 3: Gather Market Compensation Data
Use credible sources such as:
- Compensation surveys (Mercer, SHRM, Payscale, Economic Research Institute)
- Bureau of Labor Statistics (BLS) data
- Industry associations
- Job board data (Glassdoor, Indeed, LinkedIn)
This information should be adjusted for factors like geographic location, company size, and industry norms.
Step 4: Perform a Reasonableness Test
Compare actual compensation paid to:
- Market benchmarks for similar roles
- Internal equity (are others in similar roles paid comparably?)
- Company performance (are salaries in line with revenues and profitability?)
A deviation of 20–30% from market norms might be justifiable depending on the circumstances, but greater variances should be carefully documented and explained.
Step 5: Review and Document Non-Cash Compensation
Include:
- Bonuses
- Stock options or equity grants
- Company vehicles
- Health insurance premiums
- Retirement contributions
Ensure these align with company policy and are reasonable in the context of total compensation.
Step 6: Evaluate Distributions vs. Wages (for S Corporations)
In S Corps, ensure that shareholder-employees are not taking disproportionately large distributions compared to wages. If someone is actively working in the business, they must receive reasonable wages before any distributions.
Example: A shareholder who works full time and takes $150,000 in distributions but reports only $30,000 in wages will likely draw scrutiny.
Step 7: Review Corporate Governance and Compensation Policies
Formalize your compensation strategy with:
- Board meeting minutes or resolutions approving compensation
- Employment contracts or compensation agreements
- Written compensation philosophy and pay structure (e.g., salary ranges by job level)
This adds legitimacy and defensibility to your compensation practices.
Step 8: Engage an Independent Advisor (Optional)
Some companies benefit from hiring compensation consultants or tax attorneys to conduct third-party compensation studies. These experts can provide detailed reports that stand up to IRS scrutiny and help in audits or litigation.
Red Flags That May Trigger IRS Scrutiny
Be aware of these common warning signs:
- Large distributions to owners with little or no reported salary
- Inconsistently paid wages (e.g., skipping payroll during low-revenue months)
- High compensation to owners while company is unprofitable
- Compensation that far exceeds industry averages without justification
- No documentation or benchmarking to support salary levels
Benefits of a Reasonable Compensation Audit
- Reduces IRS audit risk
- Demonstrates good-faith compliance
- Strengthens internal governance
- Supports transparency and equity
- Clarifies compensation policy for stakeholders
By proactively auditing compensation practices, companies send a clear message: We take compliance seriously and operate with integrity.
Conclusion
The IRS Law of Reasonable Compensation is more than a technicality—it’s a fundamental requirement that affects how companies compensate key individuals and how much tax they owe. Organizations, especially S Corporations and closely held businesses, must ensure that pay is defensible, documented, and aligned with market norms.
By conducting regular reasonable compensation audits, companies protect themselves from penalties, build sound governance, and ensure their compensation practices reflect both legal standards and business ethics.
