S-Corp Reasonable Compensation

Shareholders of an S-Corporation who work directly for (or operate) the corporation (aka, ‘Shareholder Employees’) must be compensated with ‘reasonable compensation’ (aka, ‘salary’, ‘wage’) for the work they perform as an employee.  A shareholder employee’s salary is not the same as a shareholder’s distribution of net income (aka, ‘distribution’, ‘owners draw’) which is a separate, secondary form of compensation.  Please consider the following when determining a shareholder employee’s salary:

  1. The process of determining the shareholder employee’s salary is subjective and must be analyzed and ultimately determined by the shareholder employee (an accountant and/or tax practitioner can aide in the process but cannot determine the salary amount for the shareholder employee).
  2. The shareholder employee’s salary must be run through payroll, incur payroll taxes, and be reported on a W-2 (Note: distributions are not run through payroll).
  3. Generally, the shareholder employee’s annual salary will exceed the shareholder’s annual distributions (the IRS will re-characterize distributions as salary and penalize the taxpayer when it deems a salary is unreasonable and distributions are comparably excessive).
  4. Generally, a shareholder employee’s salary should exceed that of the highest paid non-shareholder employee.
  5. A shareholder employee’s salary should be considered in comparison to the net income of company. While subjective, the salary must pass the ‘eye test’ (i.e. it should not be unreasonably low in comparison to net income). However, a shareholder employee’s total annual salary does not need to exceed total annual net income.
  6. Perhaps the most critical element of determining the shareholder employee’s salary is the ‘market approach.’ This approach requires an analysis of comparable positions in the same geographic location. Helpful websites: https://www.bls.gov/bls/blswage.htm, https://www.comparably.com/
  7. Beyond the market approach, a shareholder employee’s salary should be determined based on the shareholder employees: training & experience, duties/responsibilities/nature/scope of work, time & effort devoted to the business.
  8. Finally, it is important for the shareholder employee to document the analysis performed in developing the salary amount, should it ever be questioned by the IRS or State.

 

  • https://www.irs.gov/pub/irs-news/fs-08-25.pdfhttps://
  • www.irs.gov/pub/irsutl/Reasonable%20Compensation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf
  • https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues