S Corporation Reasonable Compensation for Shareholders/Owners

The IRS requires S Corporations to pay a shareholder/owner as an employee reasonable compensation in return for the services that the shareholder-employee provides to the S Corporation business.  The IRS states that “generally, reasonable pay is the amount that a similar business would pay for the same or similar services.”  This is based on a variety of factors, including: the work performed; number of hours worked; market rates; experience, education and proficiency required; etc.  We strongly recommend you document your research and conclusions when determining reasonable compensation and keep this in your tax files.  If the IRS determines that your salary is inadequate, they could assess additional payroll taxes as well as penalties and interest.

How do distributions affect reasonable compensation?

The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “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.”  It doesn’t matter if the business is profitable or reporting a loss; what matters is if the S Corporation shareholder/owner is taking money (or other items of value) out of the business.  A S Corporation shareholder/owner can take just reasonable compensation, take reasonable compensation plus a distribution, or neither.  If a S Corporation shareholder/owner does not take distributions and/or reasonable compensation, it can “catch up” in a later year.

S Corporation Shareholder/Owner Compensation – Other Items to Consider

Other items to consider when evaluating S Corporation shareholder/owner compensation include maximizing retirement plan contributions, maximizing social security benefits upon retirement, S Corporation shareholder/owner health insurance, and the Qualified Business Income Deduction on the personal level.  The effects of these items vary and can be complex.  Please contact our office if you have questions or would like to discuss further.