S corp salary refers to the pay that shareholders receive as compensation for their investment in the S corporation and/or their involvement in the daily operations of the S corporation. Reasonable compensation for the shareholders of S corporations is a hot topic that many S corporation owners would like to learn more about.

About S Corporation Shareholder Compensation

The shareholders of S corporations usually prefer dividend distributions of the company's profits over compensation payments. The rationale for this is that compensation payments distributed by an S corporation are subject to payroll taxes. On the other hand, dividend distributions aren't subject to payroll taxes.

One requirement of the Internal Revenue Service (IRS) for S corporations is that these entities pay shareholders who offer substantial services. The shareholders must receive reasonable compensation. The purpose of this is to prevent shareholders and S corporations from maximizing distributions and minimizing compensation payments, thereby decreasing the amount of payroll taxes owed.

If a dispute arises between taxpayers and the IRS, the courts are required to determine whether an entity has paid shareholders reasonable compensation. Advisers can use recent district court cases as guidance when deciding whether the courts and the IRS will consider the compensation of shareholders reasonable. 

The shareholder-employees of an S corporation and their tax advisers often have different goals when determining the compensation for shareholder-employees. Usually, the shareholder-employee strives to minimize the compensation. Shareholder-employees typically prefer distributions to keep payroll taxes as low as possible.

On the other hand, tax advisers are responsible for abiding by the guidelines of the IRS. Tax advisers cannot allow the shareholder-employee to forgo compensation that is reasonable. In the past, the governing authority that tax advisers face offered very little information about how to compute compensation that is reasonable. As a result, tax advisers had little guidance to assist them in recommending salary amounts to shareholder-employees.

The Watson reasonable compensation case was decided by Watson in late 2010 by the Iowa district court. This case, as well as the North Dakota District Court's decision in the JD & Associates case in 2006, offer guidance to tax advisers related to reasonable compensation. Both cases provide tax advisers with plenty of information on the methodology that the IRS as well as the courts use to determine whether compensation is reasonable for S corporation shareholder-employees. Tax advisers can now follow an analytical approach when guiding shareholder-employees.

Before they receive their share of any profits, owners of an S corporation who also work as employees are to receive "reasonable" salaries. The IRS states that corporate officers are considered employees and that companies need to follow all the employment laws when it comes to these employees. Some of the employment laws include the following:

  • Paying payroll taxes on the salaries of the employees. Federal and state income taxes need to be withheld from these salaries.
  • Paying workers' compensation taxes and unemployment taxes on these salaries. 

The IRS guidelines offer a few factors for S corporation owners to look at. These factors can be used to determine salaries that are reasonable for corporate officers. Some of these factors include the following:

  • Training and experience
  • Dividend history
  • Duties and responsibilities
  • Compensation agreements
  • Time and effort devoted to the business 
  • The use of a formula to calculate compensation
  • Manner and timing of paying bonuses
  • Payments to employees who are non-shareholders
  • What similar businesses typically pay for comparable services

Another way that a reasonable salary for the corporate officers can be determined is by conducting research on what companies of similar type and size pay for similar services. You can look on websites like Salary.com and the Ladders to look for the salary of comparable positions. You can also refer to a compensation consultant for help.

S Corporations and Employment Taxes

Since S corporations are pass-through entities, they do not need to pay taxes at the entity or corporate level. Rather, the taxable income is distributed among the shareholders. The shareholders then report the items and pay related tax on their individual income tax returns. They need only to pay self-employment, local and federal taxes on the income that they earn as employees. 

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