As long as you do not operate as a  partnership (partners only get a draw, fully subject to all taxes, including payroll taxes), the owners of an enterprise are expected to be paid a salary.  That’s the IRS position- the one that counts.

Of course, you could attempt to transfer the net profits as a dividend to the owners, but the IRS will immediately respond that the entire transfer is subject to self employment taxes. Which means you now owe 15.3% of that transfer to the Social Security Administration (for FICA and Medicare- but you actually send the money to the IRS)- as well as income taxes (at 10, 20, 30, or 38.5%) to the Federal government and taxes (1,3,5,10 or more percent) to your local state tax authority.

So, you can see that the IRS has a desire to ensure that you pay yourself (and the co-owners) of the firm a reasonable compensation. And, to be honest, the IRS would love to demand  that distributions to sole shareholders are wholly payroll (reasonable compensation). It takes a knowledgeable tax advisor to work with single owner entities (as well as other closely-held firms) to determine what is a reasonable compensation.

First of all, if the business is truly unique or the services of the shareholder are so unique, then it is likely that no one could replace the shareholder. Think of a model, who possesses no assets- just his or her looks.  One would be very hard pressed to argue that all distributions from the business to the model were not wages.

If the entity has tangible assets, then there needs to be a return on those assets; that is also reasonable. Or, if the entity has other employees or uses contractors, these would entitle a distribution return to the shareholder(s).

But, what about intangible assets? A license to operate, goodwill, a trademarked name, even a special negotiated deal? Its true these items may not be on the balance sheet of the corporation (because they have no direct financial contribution), but they are assets. And, shareholders are entitled to profit from those assets.

How would that work? Let’s consider a small law firm. Not just a solo practitioner, but one that has employees. The valuation for such entities are valued at annual billings. (Not net profits, but gross revenue.) So, Dewey, Cheatum, and Howe is valued at $ 1.2 million. So, a return of something between $ 120K and $ 180K (10 to 15% return) would be acceptable. That would be received as a dividend, not as salary.   We also know that the staff attorneys are paid $ 95K with a bonus ranging from $ 10K to $ 20K, based upon their billable hours. That would mean the owner’s salary has to be at least the same- unless s/he has fewer billable hours.

But, what if the net profit of the firm- before including compensation (and dividends to the owner) was only $ 250K? Well, the IRS position is that reasonable compensation is based upon the value of the services provided to the corporation. And, salary is paid FIRST- before there are any dividends or distributions. And, if the corporation has assets of $ 1 KK, and the distributions have already reached $ 250K- it’s clear that the asset has already returned an adequate return to the investors. (Of course, if that asset has been replaced…)

And, then there’s the question that the IRS loves to ask… “Do you not believe that there is no replacement for your efforts in the firm?” Because most owner-operators would immediately reply there was no one who could do what they do.

Hmm. That means all the profits are a direct result of his or her efforts and must be termed reasonable compensation!

It’s why we educate the owner  to recognize that while s/he alone is the one performing all the necessary functions of the firm, a combination of others could do so. No, those folks wouldn’t stay up nights worrying from where the next dollar is coming, but that is not the same issue.  After all, stockholders in public companies also worry when their firms are not performing: Will the stock price drop?  Will they get their next dividend.

So, these owner-operators really are not that unique. (Sorry if your ego has been bruised.) But, that’s the start to discerning what is reasonable compensation.

What another person would pay you for your efforts is another parameter in the determination of reasonable compensation. (And, for those folks who started a firm because they were 50+ and no one would hire them- the starting point for reasonable compensation is a heck of a lot lower than one would think.)

Yup. Reasonable compensation requires an unreasonable amount of consideration for all the potential alternatives. But, there is at least a 15.3% return in the offing!

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