What Is a Reasonable Salary for an S Corporation Officer?

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S corporation owners are in a unique situation when it comes to federal income taxes. First, a look at why S corporations are different from corporations, and then how to avoid tax issues for owners.

S Corporations and Taxes

The S corporation (S corp) is a special kind of corporation that passes corporate taxes through to the shareholders. Then, the shareholders report this income on their personal tax returns and pay taxes on their total combined income at personal tax rates.

How S Corporation Employee Pay Works

An S corporation officer (president, chief operating officer, etc.) is considered an employee and payments they receive for their services as an employee are considered wages. This person is also an owner/shareholder but each of these roles is separate.

S Corp Officer Wages Must Be Reasonable

The IRS requires that 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."

This means the employee's wages must be reasonable compensation, not cash distributions, payments of personal expenses, or loans. The wage payments to the officer must be made first, before other distributions.

Withholding from Pay. The business must withhold FICA taxes (Social Security/Medicare) and federal income taxes from employee pay and the business must pay their share of the FICA taxes along with other employment taxes, including unemployment tax and worker's compensation.

Here's an example: Carol and John are 50/50 shareholders in an S Corp and they both work as employees in managing 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. 

The IRS can reclassify payments to shareholders from distributions that weren't correctly classified and call them wages. These wages are then subject to federal income taxes and Social Security/Medicare tax for the employee and employment taxes for the company. This may mean the employee may be charged penalties for underpayment.

How to Figure a Reasonable Salary

What does "reasonable" mean?

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.

Use Comparable Salaries to Back Up Your Salary Figures

Your ability to prove that officer salaries are reasonable will help keep you on the right side of the IRS when it comes time for them to review your company's tax returns.

Check to see what other companies of similar size and type pay for such services. Search websites like The Ladders and Salary.com for comparable positions, or hire a compensation consultant.

Medical Insurance for Corporate Officers

The IRS looks closely at payments to shareholders who own more than 2% of the shares in the company; the IRS calls them "more-than-2%-shareholders." If your company pays health and accident insurance premiums for these employees, you must include them as taxable wages for the employee. Include these medical/accident insurance payments on the shareholder-employee's Form W-2, Box 1, but not Boxes 3 and 5.

Deducting Officer Salaries as a Business Expense

Wage payments to S corp officers, including medical and accident insurance premiums, are tax-deductible to your company, in the same way as other types of employee expenses.

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-E - Compensation of Officers, 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.

S corporation taxes are complicated, and this article isn't intended to be tax or legal advice. Get help from your tax professional when you set corporate officer pay and benefits.

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