What's a "Reasonable Salary"?

If you've set up an S-corporation or a C-corporation, you'll need to research pay scales in your industry, because the IRS will want to know

I've just set up a health-care consulting business, and I understand that for tax purposes I need to pay myself a "reasonable salary." How do I determine how much is reasonable?

—T.K., Fincastle, Va.

The issue of "reasonable salary or compensation" is not something you need to worry about if you've structured your firm as an unincorporated sole proprietorship, as a partnership, or as an LLC. That's because those business entities are generally taxed as partnerships, and the income owners or partners earn from them is subject to personal income tax and self-employment tax, says Lawrence M. Gradzki, an accountant with Clifton (N.J.)-based Sax Macy Fromm & Co.

"If your business has been set up as an S-corporation or a C-corporation, reasonable compensation does become an important concept for you," Gradzki says, because IRS guidelines require both S- and C-corporations to pay reasonable compensation. "Generally, on audit, the IRS will look to see if salary to owners is too high (for C-corporation owners) or too low (for S-corporation owners)," he says (see BusinessWeek.com, 11/14/06, "The IRS Sets Its Sights on Small-Biz").

Compensation By Comparison

Because there's no hard-and-fast formula for how to determine what's considered reasonable compensation, you'll need to do some research into salaries in your industry and in your geographic area and pick an amount that's in line with what you find being paid in other companies similar to your own.

"Generally, the IRS will look to determine the amount of compensation that would be paid to an employee [doing your job] who is at arm's length—not an owner—using comparisons with similar companies, with similar services and circumstances," Gradzki says.

The issues that are generally taken into account when it comes to compensation include an employee's duties and responsibilities, the time he or she spends on the job, the complexity and income of the business, and the region where it's located. Also factor in your own abilities and accomplishments and the amount of money you earned working for other companies, Gradzki advises.

It can be tough to figure out what privately held corporations are paying. This is where networking within your industry and talking to other business owners will help.

Another good source of information comes from professional organizations and trade publications, many of which conduct annual salary surveys within their industry niches (see BusinessWeek.com, 11/20/06, "Getting the Lowdown on a Private Company").

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