What Is Reasonable Compensation for an S Corp?

An S corporation provides the liability protection of a corporation while allowing profits and losses to be passed directly to the owners’ personal income without being taxed at the corporate level. For owners who also work for the business, known as owner-employees, this structure creates a specific obligation. The Internal Revenue Service (IRS) requires that these individuals be paid a “reasonable compensation” for the services they provide.

This requirement is important for maintaining S corp status and ensuring tax compliance. The concept of “reasonable” is not defined by a specific dollar amount in the tax code, making it an area of judgment for business owners.

The S Corp Compensation Requirement

The core of the reasonable compensation requirement lies in the different tax treatments for an owner’s salary versus a distribution of company profits. When an S corp owner-employee receives a salary, that payment is considered wages and is subject to payroll taxes, including Social Security and Medicare (FICA) and unemployment taxes (FUTA). These taxes are split between the employer and the employee, with the S corporation paying the employer’s share.

Distributions, on the other hand, are payments of the company’s net profits to shareholders and are not subject to payroll taxes. This distinction creates a tax incentive for an owner to minimize their salary and take more of their earnings as distributions, thereby avoiding payroll taxes. The reasonable compensation rule exists to prevent this avoidance strategy, and the IRS mandates that any shareholder who provides more than minor services to the corporation must be paid a reasonable salary before any profits are distributed.

For example, if an S corp has $150,000 in net income and the owner classifies the entire amount as a distribution, they would avoid thousands of dollars in payroll taxes. The IRS scrutinizes these situations to ensure the salary paid reflects the actual value of the services the owner provided.

Determining a Reasonable Salary

The IRS does not provide a specific formula for calculating a reasonable salary; instead, the determination is based on the facts and circumstances of each case. The analysis focuses on what the S corp would have to pay a non-owner employee to perform the same or similar services. The IRS and courts look at a combination of factors, including:

• The owner’s training and experience. A shareholder with advanced degrees, specialized certifications, and many years of relevant industry experience would command a higher salary.
• The specific duties and responsibilities the owner undertakes, including their primary role and any administrative or management functions.
• The amount of time and effort the owner devotes to the business. An owner working 60 hours per week would justify a higher salary than one who works part-time.
• The company’s financial health, including its gross receipts and overall profitability. A highly profitable company is expected to pay a more substantial salary for the services that generated that income.

To establish a defensible salary, S corp owners should research what comparable companies pay for similar positions using resources like the U.S. Bureau of Labor Statistics, online salary websites, and industry-specific compensation surveys. Informal methods like a “60/40 rule,” where 60% of income is salary and 40% is distributions, are not sanctioned by the IRS and should be used with caution as they do not account for the specific facts of the business.

Documenting Your Compensation Decision

After determining a reasonable salary, the next step is to formally document the decision-making process, as this documentation is the primary defense in an IRS audit. One method for documentation is through formal Board of Directors meeting minutes. Even for a single-shareholder S corp, it is good practice to hold a meeting where compensation is discussed and approved.

These minutes should detail the date, the factors considered, the data sources used, and the final salary amount approved. Another method is a written compensation agreement between the S corporation and the owner-employee. This employment contract should outline the owner’s job title, duties, responsibilities, and the agreed-upon salary. Having such an agreement in place reinforces the employer-employee relationship and provides clear evidence of the intended salary arrangement.

Consequences of Unreasonable Compensation

If the IRS audits an S corporation and determines the compensation paid to an owner-employee was unreasonably low, it will take corrective action. The primary consequence is the reclassification of shareholder distributions into wages. Any payments the owner received as distributions, or even as loans, can be recharacterized by the IRS as salary up to the amount it deems reasonable.

The S corporation will be held liable for unpaid payroll taxes on the newly classified wages, including both the employer’s and employee’s share of FICA taxes and FUTA taxes. In addition to back taxes, the IRS will impose penalties, which can include failure-to-pay and failure-to-deposit penalties. An accuracy-related penalty of 20% of the underpayment may be applied for negligence or a substantial understatement of tax.

Interest will also accrue on the unpaid taxes and all associated penalties. Severe non-compliance could jeopardize the company’s S corporation status.

Paying and Reporting Owner-Employee Compensation

Once a reasonable salary is determined and documented, it must be paid and reported using formal payroll procedures. It is not sufficient to simply write a check from the business account and label it “salary”; the compensation must be processed through a payroll system. Salary payments should be made at regular intervals, such as weekly, bi-weekly, or monthly.

From each paycheck, the S corporation must withhold the owner-employee’s share of FICA and income taxes, and deposit these funds along with the corporation’s share of payroll taxes. The S corporation has several reporting obligations for this compensation:

• File Form 941, Employer’s Quarterly Federal Tax Return, to report wages paid and taxes withheld.
• File Form 940 annually to report federal unemployment tax liability.
• Deduct the owner’s salary as a business expense on the S corporation’s income tax return, Form 1120-S.
• Provide the owner-employee with a Form W-2, Wage and Tax Statement, which reports their total salary and tax withholdings for their personal tax return.