S Corp reasonable compensation can be tricky, as there are several factors that you’ll want to keep in mind when determining what constitutes a reasonable compensation.

If you are a shareholder-employee in an S Corp, you’ll want to receive dividends as opposed to compensation payments since dividends aren’t taxed. Compensation, however, is taxed at the personal tax rate.

But before you think that you can avoid paying taxes by paying yourself through dividends, keep in mind that the Internal Revenue Service (IRS) requires that all shareholder-employees receive a reasonable compensation for their work as an employee.

IRS vs. S Corp Legal Disputes

There are several disputes between IRS and S Corps that arise due to the fact that the IRS might believe that a shareholder-employee isn’t being paid a reasonable compensation. In order to avoid legal disputes arising, you and your tax adviser should work together to determine what a reasonable compensation would be for you.

Overall, you know that you cannot simply receive money only via dividends, so it is important to take several factors into account when identifying the compensation amount being paid to you.

You can take a look at the IRS guidelines, which include different factors including but not limited to the following:

  • Professional and educational background
  • Responsibilities of the employee
  • Time devoted to doing the work
  • What non-shareholder employees doing the same type of work make for the company
  • What other people make doing the same type of work

Reasonable Compensation for Different Business Structures

A key advantage of an S Corp over a C Corp is that a shareholder-employee’s shares in the corporation’s net income isn’t considered self-employment profits and therefore, isn’t subject to self-employment tax.

However, a general partner, LLC member, or sole proprietor is required to pay self-employment tax on any and all income received, even if it is in the form of a dividend.

But if the S Corp shareholder also provides services, then he or she is considered a shareholder-employee and must be paid reasonable compensation for his or her work, which will be taxed.

Taking No Salary

In a prior court case, an individual created a law firm in which he was the sole shareholder and owner of the firm. He operated as an S Corp, and while he did all of the work for the firm, he paid himself no compensation. He instead withdrew money in dividends. The district court in this case determined that, for any one shareholder-employee – particularly a sole shareholder – conducting substantial services, receiving only dividends isn’t accurate.

The Ninth Circuit Court of Appeals decided that an individual who owned and operated an S Corp with his spouse was required to pay himself reasonable compensation since he acted as the president, director, and treasurer of the business. The individual owner argued that he “donated” his services to his company instead of receiving compensation; and instead, he received distributions for the work he did.

If the court determines that the individual should be paying him or herself a reasonable compensation as opposed to only dividends, then the individual will need to re-characterize their compensation as such and pay taxes on that reasonable salary paid.

In 2005, the Treasury Inspector General for Tax Administration (TIGTA) published a report that examined the several tax advantages of operating a S Corp over sole proprietorships. Particularly, the report analyzed S Corp tax returns that were filed in 2000, and identified the following statistics:

  • Roughly 80 percent of all S Corps were owned by shareholders who had greater than 50 percent ownership in the S Corp, which meant that the shareholder-employee had complete control over his or her compensation.
  • Owners of single-shareholder S Corps paid themselves salaries that were equivalent to 41.5 percent of the S Corp’s overall profits.
  • There were 36,000 instances in which sole S Corp owners that had over $100,000 of income paid themselves no salaries. Instead, these entities failed to pay taxes on approximately $13.2 billion as those funds were passed through via dividends.
  • Payroll taxes by single-shareholder S Corps was $5.7 billion less than the self-employment tax that would have been paid if the taxpayers operated a sole proprietorship.

If you need help identifying what constitutes S Corp reasonable compensation, you can 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.