The main tax attraction of an S corporation is that distributions of profit are not subject to Social Security and Medicare taxes. The IRS counterweight is the reasonable compensation requirement: shareholder-employees who perform services must be paid reasonable wages through payroll before taking distributions. The IRS explains this on its page about S corporation employees, shareholders and corporate officers.
Why it matters
If an owner takes all profit as distributions and little or no salary, the IRS can recharacterize distributions as wages, assessing employment taxes, penalties and interest. Courts have consistently supported the IRS in such cases where owners worked substantially in the business.
Factors the IRS lists
The IRS identifies factors courts have used to determine reasonable compensation, 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
A practical approach
- List the roles the owner actually performs: for example, chief executive, lead salesperson and senior technician
- Research what the business would pay others to perform those roles, using published wage data for your area and industry
- Consider the business's capacity to pay: a startup with modest profit is not expected to pay a market salary it cannot afford, but the salary should not be zero if the owner works full time
- Document the decision in a short memo kept with the corporate records, updated annually
Distributions and basis
Distributions above salary should be made in proportion to ownership when there is more than one shareholder; disproportionate distributions can raise questions about the single class of stock requirement. They also reduce shareholder basis; see our guide to Form 1120-S.
Running owner payroll
Owner wages are processed through regular payroll with federal income tax withholding, Social Security and Medicare taxes, unemployment taxes as applicable, and quarterly Form 941 filings. Health insurance for more-than-2% shareholders is added to W-2 wages. Paying a single year-end salary is possible but makes withholding and estimated taxes harder to manage; regular pay periods are cleaner.
Interaction with other rules
Owner wages affect the qualified business income deduction and retirement plan contributions. Setting compensation is therefore a planning decision as well as a compliance one. Our payroll services set up owner payroll, and our tax services team can help document the salary decision.
Documenting your compensation decision
Keep a short memo each year explaining how the owner's salary was chosen: duties performed, hours, comparable salaries for similar roles, and the company's financial results. Update it when duties or revenue change significantly. This record is useful if the IRS asks how the amount was determined.
Bookkeeping setup
Run owner wages through payroll on a regular schedule rather than in one year-end payment, and record distributions in a separate equity account.
Revisit the salary when the business adds staff or when the owner's role changes.
Distributions should generally be made in proportion to ownership, since disproportionate distributions can raise questions about the S corporation's single class of stock.
