What Is a Reasonable Salary for an S Corporation Officer?
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 is a special kind of corporation that must be elected after the corporation is formed. (The "S" stands for the section of the tax law, not "small."). The owners of a corporation or an S corporation are shareholders, but owners of an S corporation pay tax on the income of the corporation differently from owners of a C corporation.
A C corporation pays corporate tax on its net income on a corporate tax return, and it pays dividends to the shareholders. An S corporation doesn't have a corporate tax return; the tax is passed through to the owners on their personal tax returns.
How S Corporation Owners Try to Avoid Taxes
Here's the issue: An S corporation owner who works in the business as an officer (president, chief operating officer, etc.) is considered an employee, so the owner's income is divided between the owner's share of profits and his or her income as an employee.
The business must withhold FICA taxes (Social Security/Medicare) and federal income taxes from employee pay and the business must also pay those FICA taxes along with other employment taxes (including unemployment tax and worker's compensation). Many S corporations try to avoid paying these taxes by classifying more of the owner's income as other types of payments.
Let's look at an example:
IRS Statements About S Corporation Employees
The IRS states specifically that corporate officers (president, chief financial officers, etc.) are employees and that businesses must comply with all employment laws in relation to these employees, including:
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."
Even more important, the wages paid to S corporation officers must be "reasonable."
Here's 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 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
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-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.
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.