Reasonable Compensation

Reasonable compensation is a term used by the IRS to define the compensation amount that is a deductible business expense. The issue comes up because stockholder-employees can alter their wages and income distributions to avoid taxes. Under IRC 162 (a), wages are a deductible business expense to the extent wages are reasonable. In an S Corporation, under-payment of wages occurs in order to maximize pass-through income and avoid payment of FICA and Medicare contributions. In a C corporation, wages are maximized and dividends eliminated or minimized to avoid the double taxation of dividends.