Tax laws define reasonable compensation as the amount that would ordinarily be paid for like services by like enterprises under like circumstances.
Building a compensation plan into your business right from the start is a good idea. Depending on your business structure, there are many compensation options, including:
• Standard salary—simple, easy to manage
• Salary and dividends—a mix of both wages and dividends (dividends are usually taxed at a lower rate than wages)
• Stock or stock options
• Salary with bonus option—gives yourself leeway when the business might not have a good year financially
It’s important to have proper documentation and pay yourself an amount that aligns with the size of your business, the market and related profitability. By not doing so, you are asking for trouble from the IRS in terms of additional taxes, penalties and interest.
Reasonable compensation is also a hot topic of discussion because it comes into play for determining the new qualified business income (QBI) deduction. In general terms, the QBI deduction is limited to the lesser of 20% of qualified business income or 50% of the total W-2 wages paid by the business once taxable income exceeds threshold amounts. Rules are in place to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
The complexities surrounding this deduction can be challenging but we can work through the mechanics to make sure you receive maximum results.