Cedar & Slate - S Corporation Reasonable Compensation
Cedar & Slate Design, Inc. is a calendar-year S corporation owned 100% by Priya, who works about 50 hours a week as lead designer, handles all client sales, and supervises two employees paid $58,000 and $64,000. For 2024 the company had gross receipts of $610,000 and operating expenses (other than officer compensation) of $382,000, for $228,000 of income before any salary to Priya. It paid her $42,000 of W-2 wages and distributed $96,000 to her. Priya earned $118,000 as a designer at her prior firm, and a local survey puts pay for her role at $105,000-$130,000. The corporation has no accumulated E&P. On audit, the agent proposes to reclassify $80,000 of the distributions as wages.
1. Is $42,000 reasonable compensation for Priya? Analyze the drivers and give a defensible range.
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Standard. §162(a)(1) and Reg. §1.162-7 allow a deduction only for reasonable compensation for personal services actually rendered. For an S corporation the issue is not whether the owner may take distributions, but whether wages were set at a level that would have been negotiated at arm's length.
Factors courts weigh: training and experience; duties and responsibilities; time devoted; the corporation's dividend/distribution history; pay to non-shareholder employees; comparable pay in similar businesses; whether the salary was set by arm's-length negotiation; and the corporation's gross and net income.
Applied. The facts point hard toward underpayment. Priya is the sole owner, runs sales and operations, and works ~50 hours a week. Two non-shareholder employees who report to her earn $58,000 and $64,000 - more than the owner. Her prior salary was $118,000 and the local survey is $105,000-$130,000. Meanwhile $96,000 of distributions absorbed profits that look like disguised compensation. Ability to pay is not a defense: even at a $105,000 salary, the corporation still reports roughly $123,000 of ordinary income.
Range. A defensible salary is at least the survey floor, roughly $105,000-$120,000, supported by a written compensation study in the corporate minutes.
2. If the agent reclassifies $80,000 of the distributions as wages, what changes for the corporation, for Priya, and on the payroll filings? Quantify.
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Corporation. Ordinary income falls by the reclassified $80,000 plus the new employer FICA deduction; reported ordinary income goes from about $186,000 to roughly $106,000. New liability: employer FICA of 7.65% × $80,000 = $6,120, plus the employee's 6.2% + 1.45% = $6,120, which the corporation must withhold and for which it is liable (it may recover the employee share from Priya). FUTA applies to the first $7,000 of her wages if not already maxed. Reclassified amounts are also subject to income tax withholding, a separate exposure.
Filings. Form 941-X for each quarter of 2024, W-2c and W-3c, plus failure-to-deposit penalties under §6656 and interest. The §6662 accuracy-related penalty can apply to the employment tax understatement if the position lacked reasonable support.
Priya. Her total income is essentially unchanged: $122,000 of wages plus $16,000 of distributions instead of $42,000 plus $96,000. The real cost is the $6,120 employee FICA (not deductible) plus the penalties and interest, offset slightly by the corporation's extra $6,120 deduction flowing through to her. Note the reclassification is a correction of the form of payment, not a dividend - the payments were always for services.
3. How does the salary decision interact with §199A, and what should Priya's advisor weigh in setting 2025 compensation?
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The trade-off. QBI for an S corporation is ordinary income after wages, so each dollar of salary reduces QBI by a dollar and costs roughly 15.3 cents of payroll tax (plus a small FUTA piece). But each dollar of salary also increases the business's W-2 wage amount, which is the figure that caps the §199A deduction once taxable income exceeds the threshold ($191,950 single / $383,900 married filing jointly for 2024, phased in over $50,000/$100,000). Above the threshold the deduction is limited to the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of UBIA.
What to weigh. (1) Reasonable compensation is a legal floor set by §162, independent of tax planning - do not let the §199A tail wag the dog. (2) If the deduction is wage-limited, additional salary can partly pay for itself by lifting the cap. (3) If the deduction is not wage-limited, extra salary is pure payroll tax cost. (4) Document the survey, the analysis, and the board resolution each year, because a salary set with §199A in mind is exactly what the IRS challenges - and a reclassification wipes out the planned benefit while adding payroll tax, penalties, and interest.