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: