Reasonable Compensation for S Corporation Officers

Under IRS rules, S corporation officers are treated as employees for tax purposes. This means that an S corporation must pay reasonable compensation to its officers in exchange for the services they provide instead of simply treating payments as distributions. The IRS closely looks at the compensation paid to S corporation officers and the distributions they receive to ensure that the companies are paying the employment taxes they should pay to the IRS.

Making sure to reasonably compensate a shareholder-employee through payroll services is important to protect against the assessment of additional taxes, penalties, and interest. Shareholder-employees must include their pro-rata share of the S corporation’s annual earnings in their income. However, shareholder-employees do not have to pay self-employment taxes on the distributions they receive of the S-corporation’s income, and the corporation is not required to pay employment taxes on the distributions to its officers. By contrast, both the S corporation and a shareholder-employee must pay employment taxes on compensation payments for the services provided to the corporation by the S corporation officer.

S corporations commonly attempt to claim that compensation payments are income distributions to avoid paying employment taxes. The IRS will complete a factual assessment to determine whether payments made to a shareholder are compensation for the services they have provided or income distributions.

Understanding Reasonable Pay

Before an S corporation can make income distributions to an officer, the company must reasonably compensate the officer for the services he or she has provided to the corporation. Typically, the IRS will take a close look at distributions an S corporation provides to shareholders to make certain the corporation is not trying to disguise compensation payments by calling them dividend distributions. If the IRS audits an S corporation’s return, the agency will look at whether the shareholder-employees have received reasonable salaries and whether or not the corporation has paid an appropriate amount of employment taxes.

The IRS can reclassify distribution payments as wage payments for the purpose of assessing employment taxes. Wages include all compensation for employment, including salaries, benefits, bonuses, and commissions. This means that an S corporation officer who provides substantial services to the corporation and receives remuneration of any type for the services is considered to be an employee. His or her wages are thus subject to federal employment taxes, and the corporation will also have to pay its share of the taxes on the wages.

Family Members Providing Services

Family members of S corporation officers who provide services or capital to the S-corporation must also be reasonably compensated. The IRS might order adjustments to reflect the value of the services or capital provided by the family member to the corporation. The IRS will consider how much the S corporation would have to pay to secure comparable services or capital from someone who is not a shareholder or related to one under 26 CFR § 1.1366-3. (opens new window)

If a family member of an S corporation shareholder has an interest in a pass-through entity that provides services or capital to the corporation without being reasonably compensated, the IRS can order adjustments to both the pass-through entity and the S corporation. A family member of a shareholder is defined as a spouse, ancestor, direct descendant, or a trust that has been established to primarily benefit one of these people.

What is a Reasonable Salary?

Determining what a reasonable salary is for a shareholder’s services can be murky. The IRS will review the corporation’s gross receipts and the services the shareholder provided to help the corporation generate them. A corporation’s gross receipts come from the services provided by both shareholder-employees, regular employees, equipment, and capital.

Any gross receipts with a source springing from services provided by regular employees, capital, or equipment will be viewed as income distributions to an S corporation shareholder and will not be subject to employment taxes. By contrast, gross receipts that spring from the services provided by the shareholder-employee will be considered to be wages payable through a payroll service and subject to employment taxes. Administrative work performed by the shareholder-employee will also be treated as services requiring reasonable wages even when they do not directly result in gross receipts.

Some of the factors the IRS considers (opens in new window) when determining whether a shareholder has been reasonably compensated include the following:

• His or her experience and training
• His or her responsibilities and duties
• The S corporation’s dividend history
• The amount of effort and time the shareholder has devoted to the S corporation
• Compensation paid to regular employees
• When and how key employees are paid bonuses
• Compensation agreements
• What people working for comparable businesses in similar positions are paid
• Whether a formula is used to determine compensation
• How much is paid as a salary vs. how much is distributed to the shareholder as profits

Figuring out what counts as reasonable compensation is important for S corporations and shareholder-employees. The S corporation can avoid assessments of additional taxes, penalties, and interest in an IRS audit by ensuring that each officer receives a reasonable salary for the work that he or she provides. For the S corporation shareholder, he or she will want to make sure that his or her salary is set just above the minimum threshold of reasonableness. Taking a salary

that is too high will mean that he or she will pay a lot more in employment taxes than might otherwise be required. S corporations can start by reviewing the wage data for professionals in their industries broken down by area on the website of the U.S. Bureau of Labor Statistics (opens in new window) to gain a baseline understanding of what the officers should be paid for the services and capital they provide to the corporation.