1. S Corporation Shareholder Compensation
2. The S Corporation Owner/Employee and Income Taxes
3. How S Corporation Owners Try to Avoid Taxes
4. What the IRS Says About S Corporation Employees
5. Reasonable Salary for an S Corp Owner/Employee
6. How to Determine “Reasonable Salary” in an S-corporation

What is considered a reasonable salary in an S corporation? Depending who you ask, the answer will vary. While S Corporation shareholders would rather minimize taxes by choosing to be compensated via undistributed income, the IRS views this as a loophole to avoid taxes. 

S Corporation Shareholder Compensation

Since dividend distributions are not subject to payroll taxes, S corporation shareholders receive income through dividend distribution instead of payroll compensation. Consequently, to minimize the chances of employee-shareholders who provide significant services to the corporation from avoiding payroll taxes altogether, the IRS requires S corporations to pay these employees reasonable compensation.

This requirement has led to opposing views on what is considered reasonable compensation. Thus, there are ongoing court-cases between the IRS and S corporations to determine whether this criterion is met. This rule often leads to contention between S corporate shareholder-employees and their tax advisers. 

The shareholder looks to minimize compensation by favoring distribution over compensation. However, tax advisers are subject to a governing body that sets their guideline. It's only recently that governing authority has offered guidance, which meant the tax advisers had to give it their best-educated guess.

The S Corporation Owner/Employee and Income Taxes

S corporations are treated differently when it comes to paying income tax. Unlike a C corporation, the S corporation owners, the shareholders, are responsible for their own taxes.

The S corporation shareholders only pay self-employment tax (Social Security and Medicare) on salaried income and not on their distributions. The IRS requires the shareholders that work for the S corporation (shareholder-employees) receive a "reasonable" salary before receiving their share of the profits.

For example, Carol and John both are shareholders in an S corporation. There are the only two shareholders with a 50/50 ownership. They are also the only two people that work for the S corporation. Last year their net profit was $250,000. While they would like to get paid in dividends, avoiding un-employment tax, they must first pay themselves a "reasonable" salary. The salary is subject to payroll taxes.

How S Corporation Owners Try to Avoid Taxes

S corporations find creative ways to avoid paying payroll taxes. For instance, they pay corporate officers minimal salaries and bonuses and choose to call the payouts loans payments or personal expense reimbursements.

What the IRS Says About S Corporation Employees

The IRS has an opposing stance. Since corporate officers significantly contribute their services to the company, they are considered employees and are subject to the employment laws:

  • They must make a reasonable salary and that salary is subject to payroll taxes.
  • They are also subject to federal and state income tax withholdings on their salary.
  • Lastly, they must also pay unemployment and workers compensations taxes.

Reasonable Salary for an S Corp Owner/Employee

You should designate a reasonable salary for an S Corp shareholder just like you would for any other employee.

The IRS guideline states that owner-employees compensation should be based on:

  • Training and relevant work experience.
  • Assigned duties and responsibilities.
  • The time and effort they devote to the business.
  • The way they have distributed dividends.
  • Non-shareholder employee pay.
  • The timing and the manner they pay bonuses to key employees.
  • The amount other entities similar in size pay for similar services.
  • The use of formulas for determining reasonable pay.

How to Determine “Reasonable Salary” in an S-corporation

Dr. Victorine is a dentist who runs and owns her own practice as an S corporation. She is subject to two different types of compensations: a salary for her services and shareholder distributions.  Her salary is subject to payroll taxes and her undistributed income is not.  She receives dividend income for:

  • Payment for debt services.
  • Return on capital investment.
  • Entrepreneurial profits.

Owners who are sole shareholders in an S-corporation control how they pay themselves through dividends and how much they pay themselves through distribution. There is a significant difference in these manners of income distribution; salaries and wages are subject to Federal and State payroll taxes while distributions are not.

As long as there are tax breaks through an S Corporation, its shareholders will find ways minimize income taxes. Both the IRS and S Corporations owners will always have opposing goals.

If you have questions about what is considered a reasonable salary for a corporate officer you may post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.