An S corporation owner who works in the business is an employee of it. That single fact drives the reasonable compensation issue. Wages carry payroll tax. Distributions do not. When an owner takes cash out of the company as distributions and pays little or nothing in wages, the IRS can recharacterize the distributions as wages. The firm's job is to set a salary the facts support, document the reasoning and run payroll on it.
The rule
The IRS guidance on S corporation compensation states that S corporations must pay a shareholder-employee reasonable compensation for services before making non-wage distributions to that shareholder. The Form 1120-S instructions say that distributions to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services. The IRS can reclassify payments from non-wage distributions to wages subject to employment taxes, and the guidance notes that several court cases support that authority. The IRS also notes that an S corporation cannot avoid employment tax by labeling payments as something else.
What counts as reasonable
There is no formula in the guidance. The IRS lists factors it considers, including:
- 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 bonuses to key people.
- What comparable businesses pay for similar services.
- Compensation agreements.
- Use of a formula to determine pay.
The IRS Reasonable Compensation Job Aid for valuation professionals sits behind this list for examiners. The practical point is that salary should relate to the services performed. A shareholder who works full time running a service business is paid for that work.
The gross receipts analysis
The IRS also looks at where the company's income comes from. Receipts that result from the shareholder's personal services point toward wages. Receipts from non-shareholder employees and from capital and equipment point toward profit that can be paid as non-wage distributions. The shareholder's administrative work supervising other income-producing staff or assets also counts toward wage treatment.
For a two-owner consulting firm where the owners bill all the hours, nearly all profit traces to owner services. For a company with a large non-owner workforce and heavy equipment, a larger share of profit can be attributed to capital and the workforce. The memo should say which pattern applies and why.
Building the compensation file
- Describe the role. List each shareholder's duties, hours and title. If the shareholder does more than one job, such as production and management, list both.
- Gather comparables. Use published compensation data for the role and region from a source you can cite, such as a salary survey or job postings, and save it. Attach the source to the file.
- Run the gross receipts analysis. Break profit into the portion driven by the owner's labor, other staff and capital.
- Set the number and the date. Record the salary decision, who approved it and when. Update it when duties or business size change.
- Check the pattern. Compare wages to distributions for the year. A year with wages far below the owner's value of services and large distributions is the pattern examiners look for.
- Revisit at year end. Adjust the final payrolls if the year's results change the conclusion.
Health insurance for 2 percent shareholders
Under Notice 2008-1, premiums paid by an S corporation for a more-than-2-percent shareholder-employee are deductible by the corporation and included in Box 1 of Form W-2, but they are not wages for Social Security and Medicare tax when the section 3121(a)(2)(B) conditions are met. The IRS S corporation page adds that they are not subject to FUTA when the plan covers all employees or a class of employees. The shareholder includes the premiums in gross income and can take the section 162(l) deduction on Form 1040 if the S corporation established the plan, the deduction does not exceed earned income from the S corporation, and the shareholder or spouse was not eligible for an employer-subsidized plan. The S corporation establishes the plan by paying the premiums, or by reimbursing the shareholder after proof of payment, and by including the amount in the shareholder's W-2. Without that, Notice 2008-1 denies the deduction. The IRS page also states that a 2-percent shareholder-employee is not eligible to participate in a QSEHRA and is not treated as an employee for section 125, so a cafeteria plan flexible spending arrangement is closed to the shareholder.
Interaction with other rules
- Estimated tax. Wages are withheld from. Distributions are not. A lower salary shifts the owner toward estimated payments. See estimated tax payments.
- QBI deduction. W-2 wages paid affect the limit on the qualified business income deduction at higher taxable income, while owner wages reduce QBI. The trade-off belongs in the same analysis. See the QBI deduction after the 2025 legislation.
- Payroll deposits. Once the owner is on payroll, the deposit schedule applies. See payroll tax deposits.
Common errors
- Paying no wages in a year the company had positive profit and the owner worked full time.
- Setting the salary at the start of the year and never revisiting it after income rose.
- Treating loans to the shareholder as a substitute for pay when no bona fide loan is documented.
- Missing the W-2 reporting of shareholder health insurance premiums.
FAQ
Is there a safe percentage of profit that must be paid as salary?
The IRS guidance gives factors, not a percentage. The salary has to be supportable on the facts.
Can an S corporation pay no salary in a loss year?
The test is whether the shareholder performs services and whether payments for those services are wages. A year with no profit still involves services. Document the decision.
Does this apply to partners in a partnership?
The guidance addresses S corporation shareholder-employees. Partnership payments follow different rules.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- IRS, S corporation compensation and medical insurance issues: https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues
- IRS, S corporation employees, shareholders and corporate officers: https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-employees-shareholders-and-corporate-officers
- IRS, Instructions for Form 1120-S: https://www.irs.gov/instructions/i1120s
- IRS, Notice 2008-1, Treatment of health insurance for 2-percent shareholders: https://www.irs.gov/pub/irs-drop/n-08-01.pdf
Part of CORAA University · Tax and compliance for CPA firms: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error