📋 COMPENSATION & DISTRIBUTION RULES GUIDE

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Part 3 of 3 — Companion to Entity Diagram + Salary Planning Worksheet

Compensation & Distribution Rules Guide

① Order of Operations — Payment Priority ▾
The IRS requires a specific priority order for how money comes out of pass-through entities and corporations. Skipping steps or paying distributions before reasonable compensation creates audit triggers and reclassification risk. This flowchart shows the correct sequence.
1
Reasonable Compensation (W-2 Salary) — MUST COME FIRST
Any owner who provides services to an S-Corp or C-Corp must receive reasonable compensation before any other distributions. This is non-negotiable.
IRC §162(a)(1) Rev. Rul. 74-44 David E. Watson v. U.S., 668 F.3d 1008 (8th Cir. 2012)
⚠ IRS will reclassify distributions as wages if they determine reasonable comp was not paid first — plus penalties, interest, and back payroll taxes on the reclassified amount.
Use RC Reports or comparable data to establish and document the reasonable range for each person's role at each entity.
then
2
Management Fees / Intercompany Payments
If a holding company or management company provides bona fide services to operating entities, management fees are deductible to the paying entity and income to the receiving entity.
IRC §162 IRC §482 (arm's length standard)
⚠ Must have a written management agreement, document actual services, and charge arm's-length rates. Without these, the IRS can disallow the deduction and reclassify as disguised distributions or constructive dividends.
The management company receiving fees must also pay reasonable compensation to its own service-providing owners before distributing those fees.
then
3
Retirement Plan Contributions
W-2 salary (from Step 1) drives the retirement contribution calculation. Employer contributions (Solo 401(k), SEP, DB Plan, Cash Balance) are calculated as a % of W-2 compensation.
Solo 401(k) 2025: $23,500 employee deferral + 25% of W-2 as employer match = up to $70,000 total ($77,500 if age 50+, $73,500 if 60-63 super catch-up).
Defined Benefit / Cash Balance plans allow significantly larger deductible contributions based on actuarial calculations — but require W-2 wages as the base.
⚠ If salary is set too low, retirement contributions are also capped lower. This is a key tension in salary planning — balance SE tax savings vs. retirement funding.
then
4
S-Corp Distributions — Limited by Basis
Only after reasonable compensation has been paid can S-Corp distributions be taken. Distributions are not subject to payroll taxes (the whole point of the S-Corp election).
IRC §1368 — Distributions are tax-free to the extent of the shareholder's stock basis. Distributions exceeding basis are taxed as capital gains.
Basis ordering (annual): Start with beginning basis → add share of income (K-1) → add capital contributions → subtract non-deductible expenses → subtract distributions → subtract share of losses. Basis can never go below zero.
⚠ Distributions in excess of basis = taxable gain. Track basis meticulously. The Basis Tracker in Section 4 below helps with this.
Debt basis (loans FROM shareholder TO entity) creates additional loss deduction capacity but does NOT increase distribution capacity.
then
5
Accountable Plan Reimbursements & Fringe Benefits
Reimbursements under an accountable plan (business use of home, auto, cell phone, travel) are deductible to the entity and tax-free to the owner — but must meet three requirements:
1. Business connection — expense must be business-related
2. Substantiation — receipts/records within 60 days
3. Return excess — any advances exceeding actual expenses returned within 120 days
IRC §62(c) Treas. Reg. §1.62-2
⚠ More-than-2% S-Corp shareholders: Health insurance premiums are reported on W-2 as wages (Box 1) but excluded from FICA (Boxes 3/5). This is a special rule unique to S-Corp shareholders.
finally
6
Loans, Guaranteed Payments & Special Distributions
Shareholder loans FROM entity: Must be documented with a promissory note, reasonable interest rate (use AFR), and actual repayment terms. Undocumented "loans" are treated as distributions.
Guaranteed payments (partnerships/multi-member LLCs): Payments to partners for services or capital use — deductible to the entity, ordinary income to the partner, and subject to self-employment tax. IRC §707(c)
ROBS C-Corp special rules: Salary is the only legitimate cash access. No dividends, no loans to shareholders (prohibited transactions with the 401(k)). ⚠ Violating prohibited transaction rules can disqualify the entire 401(k) plan.
⚠ The #1 Audit Trigger
S-Corp owner-operators taking large distributions with little or no salary. The IRS specifically screens for this pattern. Court cases consistently hold that owners who provide services must receive reasonable compensation, and the burden of proof is on the taxpayer to show the salary was adequate. Zero-salary S-Corps with large distributions are virtually guaranteed to lose on audit.
✎ Client-Specific Payment Order Notes
② Reasonable Compensation Rules by Entity Type ▾
Each entity type has different rules for how compensation works, what triggers reasonable comp requirements, and how money can be extracted. Understanding these differences is critical for multi-entity salary planning.
S-CORPS Corporation / LLC Taxed as S-Corp
Reasonable Comp Requirement
Mandatory for any shareholder who provides services
Must be paid before any distributions
Amount must be defensible — use RC Reports, BLS data, or comparable salary surveys
Consider: qualifications, experience, duties, time, comparable positions in the area, complexity of business
Cash Access Methods
W-2 Salary → subject to FICA + income tax
S-Corp Distributions → tax-free up to basis (no payroll tax)
Accountable plan reimbursements → tax-free to recipient
Shareholder loans → must be documented with AFR interest
Key Tax Benefit
Income above reasonable salary avoids 15.3% SE tax — the primary reason for S-Corp election. But salary cannot be artificially low.
C-CORPC Corporation
Reasonable Comp Requirement
Mandatory — but IRS concern is also about comp being too high (disguised dividends)
Excessive compensation is non-deductible to the corp and may be reclassified as a constructive dividend
Multi-factor analysis: services actually rendered, comparable compensation, corporate earnings history, dividend history
Cash Access Methods
W-2 Salary → deductible to corp, subject to FICA + income tax
Dividends → double-taxed (corp level + shareholder level at qualified rate)
Fringe benefits → more options than S-Corp (health, life, disability, meals, etc.)
Key Consideration
Balance between deductible salary (saves corp tax) vs. excess comp risk (IRS challenge). The "sweet spot" is well-documented reasonable comp.
ROBS C-CORPROBS-Funded C Corporation
Reasonable Comp Requirement
Mandatory and heightened scrutiny — IRS specifically watches ROBS structures
Salary is the ONLY way to access cash. No distributions, no loans to shareholders
Salary must be reasonable for the role — not inflated to drain corporate assets
Prohibited Transaction Rules
⚠ CRITICAL: The 401(k) plan owns the C-Corp stock. Shareholder loans, below-market transactions, or diverting assets = prohibited transaction under IRC §4975
Violating these rules can disqualify the entire 401(k) plan — all amounts become taxable + 10% early withdrawal penalty
Cash Access — Extremely Limited
W-2 Salary ONLY (reasonable for role)
Accountable plan reimbursements (documented business expenses)
NO dividends, NO shareholder loans, NO guaranteed payments
LLC / PARTNERSHIPMulti-Member LLC / Partnership (no S-election)
Reasonable Comp Requirement
Partnerships do NOT have a "reasonable comp" requirement in the same sense — partners are not employees
Instead, partners receive guaranteed payments for services (IRC §707(c)) and/or distributive share of income
All income (guaranteed payments + distributive share) subject to self-employment tax for active partners
Cash Access Methods
Guaranteed payments → ordinary income, subject to SE tax
Partner distributions → tax-free up to basis (but income already taxed via K-1)
No W-2 — partners cannot be employees of their own partnership
Why This Matters for Planning
No payroll tax savings available — this is WHY most operating LLCs elect S-Corp status once income exceeds the breakeven point (~$50-60k net income).
MGMT COHolding / Management Company
Management Fee Rules
Fees must be for actual services rendered — HR, accounting, IT, strategic management, compliance
Must be at arm's-length rates — what an unrelated party would charge for the same services
Requires written management agreement signed before services begin
The management entity must have economic substance beyond just receiving fees
IRS Scrutiny Points
⚠ Fees that exactly zero out operating entity income → red flag
⚠ No written agreement or vague service descriptions → deduction disallowed
⚠ Management company has no employees, no office, no real operations → substance challenge
Comp Rules at the Mgmt Co
If the management company is an S-Corp, the same reasonable comp rules apply at that entity — fees flow in, salary must be paid to service providers before distributions.
COMMON PAYMASTERCommon Paymaster Arrangement
Qualification Requirements — IRC §3121(s)
Entities must be in a "related group" — ≥50% common ownership (parent-sub or brother-sister)
Employee must work concurrently for multiple entities in the group
One entity is designated as the "common paymaster" — it remits all payroll taxes and is reimbursed by the others
Tax Benefit
SS wage base ($176,100 in 2025) and FUTA base ($7,000) applied once per person across all related entities
Without CPM: a person earning $160k at Entity A and $85k at Entity B pays SS tax on $176,100 at A and $85,000 at B = $245k subject to SS. With CPM: only $176,100 total.
Estimated savings: ~$10,000-17,000+ per person depending on salary levels
Documentation Required
Written common paymaster agreement between entities
Documentation of concurrent employment at each entity
Intercompany reimbursement records
Paymaster entity maintains consolidated payroll records
③ IRS Documentation Checklist ▾
The IRS examines whether documentation exists before they look at the numbers. Having these items on file is your first line of defense in any audit.
Per Entity — Compensation
Multi-Entity & Special Structures
✎ Additional Client-Specific Documentation Notes
④ S-Corp Shareholder Basis Worksheet ▾
S-Corp distributions are only tax-free to the extent of the shareholder's stock basis. This worksheet tracks basis to determine how much can be distributed without triggering capital gains.
⑤ Client Recommendations & Action Items ▾
Immediate Action Items
Risk Areas / Watch Items
Annual Review Calendar
Q1 (Jan-Mar)
• Set salary levels for year
• Review RC Reports
• File CPM designation
• Renew mgmt agreements
Q2 (Apr-Jun)
• Mid-year salary check
• Review basis capacity
• Q1 distribution reconciliation
• Retirement contribution planning
Q3 (Jul-Sep)
• Year-to-date payroll review
• Adjust salary if needed
• DB Plan funding analysis
• Basis projection for year-end
Q4 (Oct-Dec)
• Final salary adjustments
• Year-end distributions
• Retirement contributions
• Basis worksheets finalized
⑥ Complete Deliverable Package ▾
DELIVERABLE 1
Entity Structure Diagram
Client sees: "Here's your structure"
DELIVERABLE 2
Salary Planning Worksheet
Client sees: "Here's what we recommend paying"
DELIVERABLE 3
Rules & Distribution Guide
Client sees: "Here's WHY and in what ORDER"
Presentation Workflow
Step 1: Open with the Entity Diagram — walk the client through their structure.
Step 2: Move to this Rules Guide — explain payment ordering and why reasonable comp comes first.
Step 3: Present the Salary Planning Worksheet — show the specific numbers and payroll tax impact.
Step 4: Review basis worksheets and distribution capacity.
Step 5: Walk through action items and the annual review calendar.
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