For healthcare practitioners, particularly those operating S Corporations, closely held corporations, or professional service entities, determining and documenting reasonable compensation for shareholder-employees is a critical tax compliance issue. The IRS scrutinizes compensation to ensure that wages paid to owners are neither unreasonably low (to avoid payroll taxes) nor excessively high (which could trigger other tax concerns).

This guide explains why ongoing annual updates to reasonable compensation are essential, the risks of non-compliance, and best practices to maintain proper documentation and defend compensation decisions.

What is Reasonable Compensation?

Reasonable compensation refers to the amount of salary or wages paid to a shareholder-employee that is appropriate for the services rendered. It should reflect what would typically be paid for similar work in the open market, considering factors such as:

• Industry standards
• Employee’s role, experience, and qualifications
• Hours worked and responsibilities
• Company size and profitability
• Geographic location

The IRS expects businesses to pay reasonable compensation to shareholder-employees to ensure proper payroll tax withholding and to prevent tax avoidance.

Why Are Annual Updates Necessary?

1. Changing Business and Economic Conditions

• Business Growth or Contraction: As companies grow or shrink, the workload and responsibilities of shareholder-employees often change, impacting appropriate compensation.
• Industry Wage Changes: Market compensation rates fluctuate due to inflation, labor market dynamics, or regulatory changes.
• Role Evolution: Shareholder-employees may take on new roles or reduce involvement, necessitating compensation adjustments.

2. IRS Compliance and Audit Risk Mitigation

• The IRS routinely reviews reasonable compensation during audits, focusing on whether wages are artificially low to avoid payroll taxes.
• Annual updates demonstrate the business’s commitment to compliance and reduce the risk of penalties or reclassification of distributions as wages with back taxes, interest, and fines.

3. Documentation and Defense

• Maintaining contemporaneous documentation of compensation decisions and supporting data (salary surveys, job descriptions, financial statements) strengthens the company’s position in case of IRS inquiry.
• Annual reviews provide a clear record of how compensation was determined each year, showing good faith efforts to comply.

Consequences of Failing to Update Reasonable Compensation

• IRS Reclassification: The IRS may reclassify distributions or dividends as wages, triggering back payroll taxes, penalties, and interest.
• Increased Audit Exposure: Lack of documentation or failure to adjust compensation can raise red flags during audits.
• Financial and Reputation Damage: Tax liabilities and penalties can strain cash flow and damage business credibility.

Best Practices for Ongoing Reasonable Compensation Updates

1. Conduct Annual Compensation Reviews

• Review compensation levels at least once per year, ideally aligned with fiscal year-end or tax filing deadlines.
• Compare wages to industry benchmarks using reputable salary surveys or compensation databases.

2. Document the Process

• Prepare a formal compensation analysis report including:
  • Job descriptions and duties
  • Comparable market salary data
  • Financial performance of the business
  • Rationale for compensation decisions
• Keep signed resolutions or meeting minutes approving compensation levels.

3. Engage Professionals

• Work with accountants, tax advisors, or compensation consultants familiar with IRS guidelines and industry standards.
• Consider obtaining written opinions or benchmarking studies to support compensation decisions.

4. Monitor Changes in Regulations

• Stay informed of IRS guidance, court rulings, and legislative changes affecting reasonable compensation standards.
• Update compensation policies accordingly.

5. Integrate with Overall Tax Planning

• Coordinate compensation decisions with broader tax planning strategies, including retirement contributions, fringe benefits, and entity structure considerations.

Summary Checklist for Annual Reasonable Compensation Updates

Task	Description	Frequency
Review shareholder-employee roles	Update job descriptions and responsibilities	Annually
Benchmark compensation	Use salary surveys and market data	Annually
Analyze company financial performance	Assess ability to pay and profitability	Annually
Document compensation decisions	Prepare reports, resolutions, and approvals	Annually
Consult tax professionals	Validate compliance and update strategies	Annually / As needed
Stay current with IRS guidance	Monitor regulatory and legal developments	Ongoing

Conclusion

Ongoing annual updates to reasonable compensation are not just best practice—they are essential for tax compliance and risk management. For shareholder-employees and their businesses, regularly reviewing and documenting compensation helps avoid costly IRS penalties, supports sound tax planning, and ensures that compensation reflects the true value of services rendered.

By integrating these updates into an annual financial review process and working with qualified advisors, healthcare practitioners can confidently maintain compliance and focus on growth and success.