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A question was recently asked in the St. Louis Small Business Monthly by a reader who wondered whether or not he was missing the bus by not reducing his salary to a low amount, thereby being able to take more as an S-corporation distribution. We wrote about this issue in August 2008, but the short answer is that compensation must be ordinary and necessary. Ordinary, sometimes referred to as “reasonable,” can also mean that the compensation is not below what others would pay for similar services. This is especially true, and brings the attention of the IRS auditors, when owners pay themselves below market, and they have the ability to pay closer to market.

To be deductible, compensation must be “ordinary and necessary.” By paying a lower salary, the tax benefit which can allegedly be obtained is the savings of the employment taxes, amounting to 15.3 percent. However, besides calling all of your compensation and benefit plans into question if there is an IRS audit, lowering your compensation also limits the amount of qualified plan contributions which can be made for retirement purposes for the owner’s benefit, and it also reduces the amount of Social Security base to which the owner will be eligible upon his or her qualification for Social Security benefits.

We recommend that the owners pay themselves, if possible, ordinary and necessary compensation, and there are a number of ways to go about documenting what an employment position requires in terms of responsibilities and compensation in the marketplace. Certainly, excess earnings and profits can be taken as an S-corporation distribution. But tilting compensation to such a point as to cause a red flag to be waved is, from our perspective, ill advised. Especially now, in light of Obamacare’s rollout, with the IRS increasing audits for purposes of making certain that staff are properly characterized as employees and not independent contractors, why would any business owner want to unnecessarily subject him- or herself to such an audit? As we say routinely around the office, “Pigs get fat; hogs get slaughtered.” Don’t be greedy, and hopefully the IRS stays away from you and your business.