An S corporation owner who performs services for the business must receive reasonable compensation as wages before taking non-wage distributions. Setting that salary is a factual exercise, and the IRS can reclassify distributions as wages when the salary is too low.
The Rule
The IRS states that S corporations must pay reasonable compensation to a shareholder-employee in return for the services the shareholder provides before non-wage distributions may be made. The Form 1120-S instructions provide that distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.
Wages are subject to federal income tax withholding and to Social Security and Medicare taxes; distributions are not. That difference is why the IRS examines salaries that appear low relative to the services the owner performs. The IRS also notes that the amount of reasonable compensation will never exceed the total amount the shareholder receives from the corporation, directly or indirectly.
An Illustrative Court Decision
In David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), a certified public accountant practiced through his professional corporation, which paid him a salary of $24,000 in each of 2002 and 2003 while he received substantially larger profit distributions through the corporation. Relying on expert testimony, the district court found that $91,044 was a reasonable amount for his services and that his wages had been understated by $67,044, resulting in additional employment taxes. The Eighth Circuit affirmed.
Factors the IRS Considers
The IRS lists the following factors: training and experience; duties and responsibilities; time and effort devoted to the business; dividend history; payments to non-shareholder employees; the timing and manner of paying bonuses to key people; what comparable businesses pay for similar services; compensation agreements; and the use of a formula to determine compensation.
The IRS also looks at the sources of the corporation’s gross receipts. Receipts generated by the shareholder’s personal services support wage treatment, while receipts generated by non-shareholder employees or by capital and equipment support distribution treatment. Administrative and management work that the shareholder performs for the business also counts toward wages.
How to Set the Salary
Describe the role. List what the owner actually does, such as professional services, sales, management, and administration, and roughly how much time each takes.
Find comparable pay. Use compensation data for each role in the relevant market, such as published salary surveys or government wage statistics, and keep copies of the data used.
Account for the business. Consider how much of the revenue comes from the owner’s own work rather than from employees and equipment, consistent with the IRS’s gross receipts approach.
Choose and approve the figure. Select a salary within the supported range, record the reasoning, and approve it through corporate minutes or a written consent.
Pay it through payroll. Withhold and deposit taxes, file quarterly Forms 941, and issue a Form W-2.
Revisit it annually. Update the analysis when duties, hours, or the business change.
There is no IRS safe harbor that sets a salary as a percentage of profit. The salary should reflect the value of the services performed, and a record made when the salary is set is useful evidence if it is later questioned.
If the IRS Questions the Salary
If the IRS concludes that the salary was too low, it can treat part of the distributions as wages. That results in additional employer and employee Social Security and Medicare taxes and can also bring penalties and interest. The documentation described above, together with evidence of the owner’s actual duties and the market for those services, is the core of a response. Because the issue turns on facts and valuation, it is useful to have the record reviewed before responding to the IRS.
Setting Your S-Corp Salary?
Tax attorney Cassra Minai, Esq. can review your compensation and documentation in a confidential consultation.