How does profitability factor into a Reasonable Compensation calculation? That is one of the most frequent questions we receive. The short answer is: “Very little.” To help you understand why, we’ll describe a few scenarios below and next month. First, a few guidelines:

- Reasonable Compensation is based on the value of services provided, not profit or distributions.
- Wages (Reasonable Compensation) should be paid BEFORE distributions are made.
- A shareholder-employee can take wages (Reasonable Compensation) without taking a distribution, but not vice versa.
- A shareholder-employee who does not want to take any Reasonable Compensation can refuse all compensation, and play ‘catch up’ in a later year.

Keep in mind that profitability and distributions are not the same thing; they are separate and distinct events. Reasonable Compensation is not tied to Profit or Loss – it is tied to Distributions. The IRS guidelines for Reasonable Compensation state: The amount of reasonable compensation will never exceed the amounts received by the shareholder either directly or indirectly. It does not mention profit or loss at all but instead talks about ‘amounts received’ by the shareholder. It does not matter if the company is making or losing money; what matters is whether or not the S Corp owner is taking money (or other items of value) out of the S Corp.

Let’s take a look at a few examples so we can better understand the issue:

**Example 1:** Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2015 Stone Concrete had a net profit of $187,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $78,950. Scott would like to take out as much cash from Stone Concrete as he can. After consulting with his CPA, Scott elects to take $175,000 out of Stone Concrete. Scott will receive Reasonable Compensation of $78,950 and a distribution of $96,050.

Analysis: This is the simplest example of how Reasonable Compensation and Distributions relate to one another. Scott chooses the total amount he will take ($175,000); pays himself Reasonable Compensation for the services he provides his S Corp ($78,950); and makes a distribution to himself for the remainder ($96,050).

But what happens if the distribution amount is lower than the Reasonable Compensation figure?

**Example 2:** Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2015 Stone Concrete had a net profit of $43,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $78,950. Scott would like to take out as much cash from Stone Concrete as he can. After consulting with his CPA, Scott elects to take $50,000 out of Stone Concrete. Scott will receive Reasonable Compensation of $50,000 and a distribution of $0.

Analysis: IRS guidelines clearly state: S Corps must pay Reasonable Compensation to a shareholder-employee before non-wage distributions may be made. Until Scott’s total ** wage** distribution (AKA Reasonable Compensation) of $79,718 is met, he should not receive a

What happens if Scott elects to take zero distribution from his S Corp?

**Example 3:** Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2015 Stone Concrete had a net profit of $187,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $78,950. After consulting with his CPA, Scott elects to take NO distribution from Stone Concrete. Scott will receive Reasonable Compensation of $0 and a distribution of $0.

Analysis: Stone Concrete is Scott’s company and he alone gets to decide how much of a distribution will be made (if any). The IRS does not require S Corps to make distributions. Keep in mind the IRS’s guidelines: *The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.* Because Scott received no distribution, he is not required to pay himself Reasonable Compensation, either.

The last example becomes more complex because Reasonable Compensation issues can span multiple years, known as a look back period, a scenario we will explore next month along with how S Corps can be required to pay Reasonable Compensation even when they have a loss.