Reasonable compensation requirements: S corp vs C corp - what are the differences?

The reasonable compensation rules definitely apply differently between S and C corporations, but both have certain requirements. For S corps, you're right that owners must take a reasonable salary before distributions to prevent avoiding payroll taxes. The IRS scrutinizes S corps closely when owners take minimal salaries and large distributions because this can be seen as avoiding Social Security and Medicare taxes. For C corps, the concern is actually reversed! The IRS worries about excessive compensation to owner-employees, not insufficient salary. This is because C corp profits are subject to double taxation (corporate level + dividend level) while salary is only taxed once but is deductible to the corporation. So C corp owners have incentive to take higher salaries to avoid corporate tax, which is why the IRS might challenge unreasonably HIGH compensation in C corps. You technically could take only dividends from a C corp, but you'd likely pay more tax overall due to the double taxation on dividends and loss of the salary deduction at the corporate level. Plus, if you're working for the business, the IRS would expect some reasonable compensation for your services.

After dealing with this exact issue last year, I found taxr.ai (https://taxr.ai) to be super helpful for understanding reasonable compensation requirements. I was switching from an S corp to a C corp and was totally confused about how my salary requirements would change. Their system analyzed my business financials, industry standards, and my actual role in the company to determine appropriate compensation ranges for both entity types. The report they generated showed me side-by-side comparisons of tax implications under different compensation scenarios. I really liked that they showed exactly how the IRS views "reasonable compensation" differently between S and C corps - exactly what you're asking about!

Alright, I need to eat my words. I tried taxr.ai after posting my skeptical comment and it was actually really insightful. I've been running a small marketing agency as an S-corp and considering a switch to C-corp status. The analysis broke down exactly how my tax situation would change under both scenarios with different compensation structures. What surprised me most was seeing the exact point where taking more salary vs. distributions would flip from beneficial to detrimental in each entity type. The report also highlighted that in my specific industry and region, my current compensation was actually on the low end of reasonable, which could potentially raise IRS flags. Definitely more comprehensive than the generic advice I've been getting.

If you're dealing with compensation questions for either entity type, getting through to the IRS for clarification can be nearly impossible. I was on hold for HOURS trying to get guidance about reasonable compensation requirements after my accountant gave conflicting advice. Finally tried https://claimyr.com after seeing it mentioned here, and you can watch how it works at https://youtu.be/_kiP6q8DX5c - they got me connected to an actual IRS agent in less than 20 minutes. The agent confirmed that while S corps have explicit reasonable compensation requirements to prevent payroll tax avoidance, C corps have different but equally important considerations around unreasonably high compensation. They explained that the IRS looks at both extremes and provided specific guidance for my situation. Saved me tons of uncertainty and potential audit risk!

I was completely wrong about Claimyr. After posting my skeptical comment, I decided to try it because I've been frustrated trying to get clarity on some C-corp compensation questions. Got connected to an IRS representative in about 15 minutes after spending literal DAYS trying on my own. The agent walked me through the key differences in how they evaluate compensation between S and C corps. For C corps, they're actually looking for unreasonably HIGH compensation since that reduces corporate tax. They explained that they consider factors like industry standards, time worked, skills required, and business performance. While they couldn't give me a specific number, they confirmed my documentation approach was solid and suggested additional records I should keep. Definitely worth not spending hours on hold!

Just to add a real-world example - I switched from S to C corp last year. In my S corp, I was paying myself $90K salary with about $60K in distributions (web development business). After switching to C corp, my accountant actually recommended increasing my salary to about $120K and taking less in dividends. This seemed weird until she explained that the corporate tax rate of 21% was actually lower than my personal rate on the dividends after accounting for the additional 3.8% NIIT tax plus regular income tax on qualified dividends. Every situation is different, but in my case, the math worked out better with higher salary in the C corp structure.

Has anyone else run into issues with state tax authorities being even more aggressive than the IRS on reasonable compensation? My accountant just warned me that my state (CA) is starting to audit S corps specifically looking for unreasonable compensation.

This is exactly the kind of question that trips up so many business owners! The key difference is that S corps and C corps have opposite reasonable compensation concerns from the IRS perspective. With your S corp, you're absolutely right to be careful about maintaining adequate salary vs distributions. The IRS wants to see reasonable compensation because S corp distributions aren't subject to payroll taxes, so they're watching for owners who try to minimize salary to avoid Social Security and Medicare taxes. But here's where it gets interesting with C corps - the IRS actually worries about the opposite problem. Since C corp salaries are deductible at the corporate level (reducing corporate taxable income) while dividends face double taxation, the IRS is more concerned about unreasonably HIGH compensation in C corps. Owner-employees have an incentive to take excessive salaries to avoid the corporate tax, so that's what triggers IRS scrutiny. You technically could take minimal salary and maximum dividends from a C corp, but the double taxation on dividends usually makes this a poor strategy from a total tax perspective. Plus, if you're actively working in the business, the IRS still expects some reasonable compensation for your services - just like any other employee performing similar work would receive. The "reasonableness" test considers factors like your role, industry standards, time commitment, qualifications, and company performance - regardless of entity type.

One thing that often gets overlooked in this S corp vs C corp compensation discussion is the impact of your long-term business goals. If you're planning to reinvest profits back into the business for growth, a C corp structure might actually work better even with the double taxation concern. Here's why: With an S corp, all profits flow through to your personal return whether you take distributions or not - meaning you pay personal income tax on retained earnings. With a C corp, you only pay the 21% corporate rate on retained profits, which could be lower than your personal rate if you're in higher tax brackets. So while the reasonable compensation rules do flip between entity types (S corps worry about too little salary, C corps about too much), your decision should factor in your overall business strategy. If you're taking most profits out annually, S corp probably still wins. But if you're planning to keep significant profits in the business for expansion, equipment purchases, or building cash reserves, the C corp might be worth considering despite the compensation complexity. The reasonable compensation requirements exist in both structures - they just point in opposite directions based on the underlying tax incentives each entity type creates.