Reasonable compensation is the salary an S corporation must pay an owner who works in the business before taking distributions, measured by what the business would pay someone else for the same services.
The IRS and courts look at duties, hours, training, comparable pay, and the business’s revenue. Paying a nominal salary and large distributions is the most common S corporation audit adjustment, and the reclassified amount carries payroll tax and penalties.
Why it matters: the S corporation’s savings are real only if the salary is defensible.
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