What Is a Reasonable Salary for an S Corporation Officer?
S corporation owners (actually, shareholders) are in a unique situation when it comes to income taxes. The S corporation, unlike a corporation, passes through the taxes of the business to the owners, while a C corporation pays its own taxes.
S corporation shareholders don't pay self-employment taxes (Social Security and Medicare) on their distribution from the business. But S corp owners who work as employees must be paid a "reasonable" salary," before their share of the profits.
Let's look at an example:
Carol and John are 50/50 shareholders in an S Corp and they both work in the business. Their net profit last year was $250,000. They would like to split the profits and take them as a distribution, to avoid self-employment tax, but since they work in the corporation, they must first take a "reasonable" salary.
How S Corporation Owners Try to Avoid Taxes
Some S corporation shareholders who are officers of the company attempt to avoid paying employment taxes by minimizing the salaries and bonuses they pay to corporate officers and instead considering payments as loan payments or payments of personal expenses.
IRS Statements About S Corporation Employees
The IRS notes in an article about Wage Compensation for S Corporation Officers:
"The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages."
Reasonable Salaries Factors for an S Corp Owner/Employee
To find a reasonable salary for an S corporation owner/employee, consider how you would find a reasonable salary amount for any new employee. The IRS guidelines suggest you look at the following factors to determine "reasonable" salaries for your corporate officers:
- 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
Using Comparable Salaries to Back Up Your Salary Figures
Another way to determine a reasonable salary for corporate officers is to look at what other companies of similar size and type pay for such services. Check on websites like The Ladders and Salary.com for comparable positions, or engage the services of a compensation consultant.
Your ability to substantiate the salaries you are paying to top executives and corporate officers will help keep you on the right side of the IRS when it comes time for them to review your company's tax returns.
Reporting Officer Salaries to the IRS
Each year, when you complete the income tax forms for your corporation or S corporation, you must report corporate officer salaries if the corporation's total receipts are $500,000 or more. You will need to use IRS Form 1125, listing compensation for each corporate officer, along with information about the percentage of time devoted to the business and the percentage of stock owned by this officer.
The IRS limits the amount a corporation can deduct for corporate salaries; the IRS says
Publicly held corporations cannot deduct compensation to a “covered employee” to the extent that the compensation exceeds $1 million.