Determining appropriate compensation for shareholder-employees in an S corporation is a critical aspect of tax compliance. The Internal Revenue Service (IRS) requires that S corporation owners who perform services for the business receive a “reasonable salary” before taking distributions. This salary is subject to employment taxes, such as Social Security and Medicare, while distributions are generally not. A reasonable salary reflects the fair market value of the services the shareholder-employee provides to the company. For example, an S corporation owner operating as a software developer should receive a salary commensurate with what other software developers earn in similar roles and locations.
Establishing a reasonable salary is vital for several reasons. Underpaying shareholder-employees can trigger an IRS audit and potential penalties. The IRS may reclassify distributions as wages, resulting in back taxes, interest, and penalties on unpaid employment taxes. Conversely, overpaying can reduce the amount of pass-through income to the shareholder-employee, potentially increasing overall tax liability. Historically, this issue has been a point of contention between the IRS and S corporations, leading to numerous court cases and rulings that emphasize the importance of careful documentation and justification for the salary chosen.
