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Shareholder-Employee of an S Corporation: Are You Paying Yourself Reasonable Compensation?

An S corporation is a corporation that elects to pass its corporate income, losses, deductions and credits through to its shareholder(s). A shareholder of an S corporation reports the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.

When a corporate officer performs services for the S corporation and receives or is entitled to receive payments, their compensation is generally considered wages. Does it mean the corporate officer is an employee?

Who is an employee of the S corporation? The IRS states specifically that corporate officers are employees and that companies must comply with all employment laws in relation to these employees, including: 1) Paying payroll taxes on their salaries and withholding federal and state income tax and from these salaries; 2) Paying unemployment taxes and workers compensation taxes on the salaries. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages.

The IRS requires that all shareholders of S corporations who perform services for their company pay themselves Reasonable Compensation, and it should be paid prior to taking any distributions. S corporation shareholders don’t pay self-employment taxes (Social Security and Medicare) on their distribution from the business. Because S corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses or loans rather than wages. the IRS has began taking aim at taxpayers who abused the employment tax advantage of S corporations by minimizing salary. Shareholder-employees who opted to forgo salary in favor of distributions, have found themselves in a situation where the courts have recharacterized the distributions as compensation under the principle that any employee who renders significant services to an employer must be paid “reasonable compensation.”

What is Reasonable Compensation? Reasonable Compensation is defined by the IRS as “The value that would ordinarily be paid for like services by like enterprises under like circumstances”. Therefore, it is the salary or wages that you, the shareholder-employee of an S corporation, pay yourself for the work you perform for your company.

Some factors considered by the courts in determining reasonable compensation are:

  • 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 to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of a formula to determine compensation

Another way to determine a reasonable salary for corporate officers is to look at what other companies of similar size and type pay for such services. As a shareholder employee, the key to establishing reasonable compensation is determining what you do for your S corporation. You might be doing more than just generating revenue for your business, you are probably also involved in administrative work. It is important that you research and document how you reach your Reasonable Compensation amount and be able to substantiate the salaries you are paying that will help keep you on the right side of the IRS when it comes time for them to review your company’s tax returns. The best time to establish your Reasonable Compensation amount is before an IRS examination.

Written by Esther Phahla

Esther Phahla is a Certified Public Accountant and Certified Tax Coach in Temecula. She also holds a Masters of Science in Taxation. She is the Best Selling Co-Author of a Tax Planning book “Why Didn’t My CPA Tell Me That”. She can be reached at (951) 514-2652.

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