8 Factors to Consider to Determine Reasonable Compensation

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The factors to be considered in establishing that compensation paid to a shareholder-employee of an S corporation is reasonable are the same as those that apply to a C corporation.  These factors include:

1. The prevailing compensation rates and packages of similarly situated employees in the corporation’s industry.
2. The shareholder-employee’s qualifications and abilities. These qualifications and abilities should be documented in the personnel file.
3. The degree to which the shareholder-employee contributes to the success of the business.  This should be documented in the personnel file.
4. The relationship between the shareholder’s stock ownership and the amount of compensation paid to each shareholder. The corporation should avoid compensating shareholder-employees in proportion to their stock ownership.
5. Whether the shareholder-employee was adequately compensated in prior years. Inadequate compensation is common in initial years when funds are typically reinvested to promote growth. Thus, the shareholder-employee can make up for the prior inadequate compensation in future years. Compensation paid currently for past services should be documented in a corporate resolution that also states why the employee’s past compensation was inadequate.
6. The overall size and complexity of its business operations.
7. The timing of the compensation (i.e., is it paid only after profits for the years can be determined, or are wages set early in the year before the amount of actual profits is known).
8. The ratio of compensation paid to other factors such as the net profits of the company.

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