S Corporation Shareholder(s)’ Compensation

S corporations MUST pay reasonable compensation to a shareholder-employee in return for services that the shareholder-employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. If it is determined that reasonable compensation is not being paid, distributions and other payments made by an S corporation to a shareholder may be treated as wages to the extent of the underpayment of reasonable compensation for the services rendered.  The amount of the reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly. 

Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as wages and subject such as payments to employment taxes, as well as other various penalties and interest.

Here are some factors in determining reasonable compensation:

• The amount of personal service by the shareholder involved in generating revenue
• Training and experience
• Duties and responsibilities
• Time and effort devoted to business
• Payments to non-shareholders
• 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
• History of distributions

Important Note:   Due to increased IRS scrutiny, we may not be able to sign your S corporate return if the compensation to the shareholder(s) is not reasonable or is missing. Restating distributions or other payments as wages and filing or amending appropriate payroll tax returns may be necessary and may result in significant late filing and late payment penalties and interest.

Also, note that it is anticipated that there will be increased IRS scrutiny with respect to shareholder compensation because of the complications of the 199A deduction. Our recommendation is that you have documentation to justify why your salary is reasonable.

Contact us as soon as possible if you have any questions or concerns about this issue.