If there is only one shareholder and no other employees, should all distributions be taken out as Reasonable Compensation?
- If the business or the services of the shareholder are so unique that no one replace the owner and there are no other assets in the corporation, then everything taken out of the business should be treated as wages (Reasonable Compensation) and nothing should be considered a distribution.
- If the corporation has tangible assets, such as equipment or inventory, the owner deserves a return on that investment. Likewise, if the business has employees or uses contractors, the owner deserves a return on that investment as well.
- If the corporation has intangible assets, such as goodwill, a license to operate or a favorable lease, the shareholder should receive a return on these assets. These assets may or may not have a tax basis. An example of this would be internally developed goodwill.
Reasonable Compensation is based on the value of services provided by the shareholder to the corporation. Any additional cash available for withdrawal from the business can be taken out in the form of a distribution of earnings and profits. Reasonable Compensation must be paid before distributions are made. The return on investments accumulated since inception should be equal to or greater than the accumulated distributions. If the accumulated distribution exceeds the accumulated return on investments, all assumptions need to be reviewed and adjusted. It may be necessary to adjust the Reasonable Compensation, the value of the assets or the return on investments.
Single shareholder employees of S corporations only providing services will frequently assert that they cannot be replaced. While this may be true on rare occasions, more than likely they have answered incorrectly. It may be that they do not fully understand the question. Any discussion about replacing a business owner within a company in relation to Reasonable Compensation, is about the hypothetical replacement cost of the owner. Small business owners often believe that they are irreplaceable assets, when in reality all the services they perform can be done by others. The owners think of their consideration devotion to the company, sleepless nights, and other intangibles. While this is probably true, it is again a matter of the hypothetical replacement of the owner.
If you have questions about the amount of compensation that you are taking from your S Corporation, call us to discuss.