Reasonable Compensation

Reasonable compensation is the deductible amount of what a business pays for personal services. The Internal Revenue Code does not use the two-word phrase; section 162(a)(1) allows as an ordinary and necessary business expense "a reasonable allowance for salaries or other compensation for personal services actually rendered." The IRS's own consumer-facing material shortens that to "reasonable compensation," which is the term that circulates, and both refer to the same standard.

The implementing regulation, 26 CFR 1.162-7(a), states the test in one sentence: "The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services." Those are two separate hurdles. A payment can be perfectly reasonable in size and still fail, if what it is really buying is something other than work.

The two directions of the same rule. Which way reasonable compensation cuts depends entirely on the entity's tax treatment, and the two cases are mirror images.

In a C corporation, wages are deductible at the entity level and dividends are not, so an owner-employee has an incentive to characterize distributions as salary. 26 CFR 1.162-7(b)(1) addresses that directly: "Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock." The regulation then names the pattern to watch for. "This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock." Salaries that track ownership percentages are the tell.

In an S corporation, there is no entity-level tax and distributions escape employment tax, so the incentive reverses: an owner-employee has reason to take a small wage and a large distribution. The IRS's position is that "S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee." That direction, including the payroll-tax arithmetic, is treated on our S corporation pages.

The same regulation carries an underrated escape hatch for contingent pay. 26 CFR 1.162-7(b)(2) says the form of the arrangement is not decisive, and that "if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid." A commission or profit-linked bonus negotiated at arm's length before the work, in other words, is not made unreasonable by turning out well.

The measuring date is the arrangement date. 26 CFR 1.162-7(b)(3) supplies both the benchmark and the timing: reasonable compensation is "only such amount as would ordinarily be paid for like services by like enterprises under like circumstances," and "the circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned." That is the reason documenting the reasoning at the time an owner sets their own pay is worth more than reconstructing it during an examination.

What the IRS actually looks at. For the S-corporation case the agency describes the analytical starting point as the source of the corporation's gross receipts, split three ways: services of the shareholder, services of non-shareholder employees, and capital and equipment. To the extent receipts come from the shareholder's personal services, payments to that shareholder "should be classified as wages"; to the extent they come from other employees or from capital and equipment, payments "would properly be treated as non-wage distributions." The agency then lists factors it weighs: training and experience; duties and responsibilities; time and effort devoted to the business; dividend history; payments to non-shareholder employees; timing and manner of paying bonuses to key people; what comparable businesses pay for similar services; compensation agreements; and the use of a formula to determine compensation.

There is no percentage safe harbor. The regulation is a facts-and- circumstances standard and the IRS publishes no ratio of salary to distributions that is presumptively acceptable. Rules of thumb circulate widely and none of them has an authority behind it.

Setting compensation defensibly is a documentation exercise done in advance, not a calculation.

1. Describe the job. What the person actually does, how many hours, what responsibility they carry, and what qualifications the role requires.
2. Find the comparison. 26 CFR 1.162-7(b)(3) sets the benchmark as what "would ordinarily be paid for like services by like enterprises under like circumstances," so the comparison is industry, region and size, not the owner's cash needs.
3. Decide before the services are rendered, and record the decision. Contingent pay in particular is protected by 1.162-7(b)(2) only if the bargain was struck up front.
4. Test it against the ownership pattern. If several shareholders draw salaries that fall in the same proportions as their shareholdings, the regulation itself flags that as a likely disguised dividend.

A hypothetical shows the C-corporation direction. Two siblings own a manufacturing C corporation 70/30 and both work in it. The corporation earns $400,000 before any owner compensation and pays them $280,000 and $120,000 in salary, exactly 70 percent and 30 percent, leaving no taxable income at the entity level. Comparable firms pay roughly $150,000 for the elder sibling's role and $130,000 for the younger's. On examination the IRS accepts $150,000 and $130,000 as reasonable and treats the remaining $130,000 paid to the elder sibling as a dividend. Two things happen: the corporation loses a $130,000 deduction, so at the 21 percent rate in section 11(b) it owes an additional $27,300 of entity-level tax, and the $130,000 stops being wages in the sibling's hands and becomes a dividend, taxed at the qualified dividend rates if it meets those requirements rather than as ordinary wage income. The younger sibling, paid $120,000 against a $130,000 benchmark, is not affected. These are hypothetical figures illustrating the mechanism, not a prediction of any actual outcome.

Why the standard exists and what it does well

• It stops a closely held corporation from converting non-deductible distributions into deductible salary simply by relabeling them.
• It stops an S-corporation owner from converting wages into distributions to escape employment tax.
• The free-bargain rule in 26 CFR 1.162-7(b)(2) protects genuine incentive pay that turns out well, so a business is not penalized for a successful commission plan negotiated in advance.
• Judging reasonableness as of the arrangement date rewards a business that documents its thinking when it sets the pay.

Where it is hard to live with

• It is a facts-and-circumstances standard with no bright line, so a business acting in good faith cannot be certain in advance.
• The comparability data that would settle it is often thin for a small or unusual business, and the burden of producing it falls on the taxpayer.
• The consequence in a C corporation is doubled: the entity loses the deduction and the owner's income is recharacterized in the same adjustment.
• The rules of thumb that circulate to fill the gap have no authority behind them, and relying on one is not a defense.