What does it really mean?  And why you should care!

If you’re in business, you’ve probably noticed the term “Reasonable Compensation” has been in tax news more than ever in recent months.  It’s not a new term, but it is receiving new attention by the IRS.

Who should care?

Anyone associated with a Subchapter S Corporation.  You might call yourself an owner or a shareholder or even a partner.   (I’m going to use ‘owner’ because it is short.)

Why?

How to head off under-withholding penalties

Let’s say you run a business, and take a small salary.  And let’s say you had a great year!  If your business is an LLC or S Corp, or even a sole proprietorship, that great year is going to find its way to your personal 1040, and you’re going to have to pay tax on it.

But you’re already contributing with withholding from your small salary, right?  Isn’t that good enough?  Well, if it’s been enough in prior years, and this year is especially good, then probably not.  And not only will you owe income tax and self-employment tax, but you may be subject to underpayment penalties.

The IRS (and the State of New Jersey, as well as most other taxing jurisdictions) expects you to contribute “ratably” throughout the year, just like a W2 employee.  It goes like this:  a W2 worker has taxes withheld every time he or she gets paid.    If the paycheck is large, the government gets more.  If the paycheck is tiny, the government gets less.  But either way, the government gets its cut way before April 15.  And they want this from the self-employed community, too.