The instructions for the S Corporation income tax return for page 1, line 7, Officer’s Compensation, begin with “Caution! Distributions and other payments by an S Corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
Reasonable compensation for S Corporation officers has long been a sore spot for the IRS. For years, many S Corporations have paid officers through distributions from the corporation to avoid having to pay employment taxes (Social Security and Medicare taxes, Federal Unemployment taxes). I expect the reason the instructions start off with “Caution!” means they are on the lookout for non-compliance.
Reasonable compensation is a less than well-defined term. There is no chart to look up how much you should pay yourself. For corporations that did not elect to be taxed as an S Corporation, the IRS gets excited when the officers’ compensation is unreasonably high. For S Corporations the IRS gets excited when the officers’ compensation in unreasonably low.
Here are the factors the IRS tells you to consider in determining a reasonable salary:
- 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
- The use of a formula to determine compensation
What happens when the IRS audits an S Corporation where the owners\officers pay themselves distributions in lieu of a salary? They generally treat all the distributions as compensation subject to employment taxes, assess you Social Security and Medicare taxes, tack on some penalty and interest, and ask you for a check. (That doesn’t mean you should accept their assessment without challenge. It just means you will have to fight to prove reasonable compensation based on your facts and circumstances, a fight that could be prevented with proper planning.)
If you are an S Corporation owner/officer that hasn’t paid yourself a reasonable salary in 2012, you need to pay it before December 31. If you need help in determining what reasonable compensation is, call us. We can help.