An S corporation shareholder who works in the business must be paid reasonable compensation as wages before taking non-wage distributions. Because wages are subject to employment taxes and distributions are not, the IRS looks at whether an owner’s salary reflects the value of the services the owner provides.
Why Reasonable Compensation Matters
Wages paid to a shareholder-employee are subject to Social Security and Medicare taxes and income tax withholding. Distributions of S corporation profits are not subject to those employment taxes. That difference creates an incentive to pay a low salary and take more of the profit as distributions.
The IRS addresses this directly. According to the IRS, S corporations must pay reasonable compensation to a shareholder-employee in return for services the employee provides to the corporation before non-wage distributions may be made to that shareholder. The Form 1120-S instructions state 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. Courts have upheld the IRS’s authority to reclassify such payments as wages.
If distributions are recharacterized as wages, the corporation can be assessed the related employment taxes, along with interest and, where applicable, penalties.
Factors the IRS Considers
Neither the Internal Revenue Code nor the regulations set a fixed percentage or formula for reasonable compensation. The IRS lists factors that courts have considered, including:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
Where the Gross Receipts Come From
The IRS also looks at the source of the corporation’s gross receipts. Receipts may come from the shareholder’s personal services, from the services of non-shareholder employees, or from capital and equipment. To the extent receipts are generated by other employees or by capital and equipment, they are associated with the business rather than the shareholder’s own work, and non-wage distributions may be appropriate. When most of the receipts come from the shareholder’s personal services, most of the payments to that shareholder should generally be classified as wages.
There is no safe percentage of profit that automatically qualifies as reasonable compensation. The question is what the owner’s services are worth, based on the factors above and the source of the business’s receipts.
Documenting a Salary Decision
Because the analysis is factual, the record matters. Documentation commonly includes a description of the owner’s duties, an estimate of time spent in each role, the owner’s qualifications, compensation data for comparable positions from published wage surveys or industry sources, and the reasoning used to arrive at the salary, preferably prepared when the salary is set rather than after an examination begins.
The requirement is tied to services performed. A shareholder who does not work in the business is generally not required to receive wages, though shareholders who perform even part-time services should be compensated for them.
Payroll Mechanics
Shareholder wages must be paid through payroll, with income tax and employment tax withholding, deposits, and quarterly and annual payroll returns, just as for any other employee. If an owner’s salary turns out to be too low for the services performed during the year, an additional payment such as a bonus can be run through payroll before year-end. All wages for the year are then reported on a single Form W-2.
Health insurance premiums paid by the S corporation for a more-than-2-percent shareholder-employee are reported as wages on the shareholder’s Form W-2 and are subject to income tax withholding. According to the IRS, they are not subject to Social Security, Medicare, or federal unemployment taxes if paid under a plan or system covering all employees or a class of employees, and the shareholder may be able to claim an above-the-line deduction for the premiums if the other requirements are met.
Interaction With the QBI Deduction
The §199A qualified business income deduction, which the One Big Beautiful Bill Act made permanent, does not apply to reasonable compensation an S corporation pays to its owner (§199A(c)(4)). The salary level therefore affects both employment taxes and the QBI deduction, and the two should be considered together.
The Bottom Line
Reasonable compensation is a facts-and-circumstances determination. Setting the salary based on the owner’s actual duties, time, and qualifications, comparing it with what similar businesses pay, and documenting the reasoning at the time the decision is made are the most reliable ways to support the position if the IRS asks.
Setting an S corporation salary?
Tax attorney Cassra Minai, Esq. can review your compensation approach in a confidential consultation.