Key Takeaways

  • The IRS requires S corporation shareholder-employees who provide significant services to receive a “reasonable salary” before taking profit distributions.
  • Reasonable salary determinations consider factors like industry pay standards, the owner’s role, time commitment, training, and the business’s financial condition.
  • Paying too little salary can trigger IRS audits, back taxes, penalties, and interest; overpaying can unnecessarily increase payroll taxes.
  • Common methods to establish reasonable compensation include market salary research, IRS guidance, and formal documentation of the calculation process.
  • Using payroll systems and keeping detailed records can help ensure compliance and defend against IRS scrutiny.

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.

Why the IRS Enforces the Reasonable Salary Rule

The IRS enforces the reasonable salary requirement to prevent shareholder-employees from avoiding payroll taxes by labeling most of their compensation as distributions. Since distributions are not subject to Social Security and Medicare taxes, misclassifying them can significantly reduce tax liability. However, this practice undermines payroll tax collections, which fund essential federal programs. The reasonable salary rule ensures that shareholder-employees contribute their fair share, aligning their tax obligations with those of other wage earners. Failure to comply may lead to audits, where the IRS can reclassify distributions as wages, impose back taxes, and assess penalties.

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.

Risks of Misclassifying Distributions

Misclassifying earnings by taking minimal or no salary while drawing large distributions is one of the most common triggers for IRS scrutiny of S corporations. The IRS can recharacterize excessive distributions as wages, leading to:

  • Payment of back payroll taxes, plus interest.
  • Penalties for failure to pay and deposit employment taxes.
  • Additional income tax liability if prior filings are adjusted.

In severe cases, repeated violations can escalate into legal action. To minimize risk, S corporation owners should establish a salary using clear, objective criteria and document the rationale behind it.

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.

Factors That Strengthen Your Salary Determination

When determining what is a reasonable salary for an S corp owner, consider combining multiple data sources and documentation practices:

  • Industry salary surveys: Compare pay for similar roles in businesses of comparable size and location.
  • IRS Fact Sheet 2008-25: Follow the IRS’s outlined factors, such as the nature of duties, training, and comparable employee wages.
  • Business performance: Align salary with the company’s revenue and profit trends.
  • Owner’s role evolution: Adjust salary as your responsibilities or hours worked change.
  • Third-party payroll service recommendations: Independent assessments can help validate your figure.

Keeping detailed notes on these considerations strengthens your position in the event of an IRS review.

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.

Methods to Calculate Reasonable Salary

There is no single formula for setting a reasonable salary, but several accepted approaches can guide your decision:

  1. Comparable salary method – Research market rates for similar positions using tools like the Bureau of Labor Statistics, Glassdoor, or PayScale.
  2. Cost approach – Base salary on the cost of replacing you with someone of similar skill and experience.
  3. Income percentage method – Allocate a set percentage of company profits as salary, ensuring it meets or exceeds industry norms.
  4. Blended approach – Combine elements from multiple methods for a more tailored figure.

Regardless of the method, apply it consistently year over year and keep evidence of your calculations for at least three years.

Frequently Asked Questions

1. What happens if I don’t take a reasonable salary from my S corp?

You risk IRS audits, reclassification of distributions as wages, back taxes, penalties, and interest.

2. Can I change my salary during the year?

Yes, but adjustments should reflect changes in business performance or your role, and should be documented.

3. Is there a minimum salary I must take?

There’s no fixed minimum, but it must be “reasonable” based on IRS criteria like duties, experience, and industry standards.

4. How can I prove my salary is reasonable?

Maintain records of market salary data, your job duties, time spent, and the method used to calculate the amount.

5. Do distributions affect my reasonable salary calculation?

Yes, excessive distributions compared to a low salary can signal to the IRS that your pay may not be reasonable.

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