Reasonable Compensation and S Corps in 2024

what do you need to know about reasonable compensation?

Unlike a C corporation, which pays taxes on its income, an S corporation distributes its income, losses, deductions, and credits to shareholders’ individual tax returns on a pro-rata basis. These distributions aren’t subject to self-employment (Social Security and Medicare) taxes.

The Need for Reasonable Compensation

Many S corporations overlook the requirement that each shareholder-employee must take reasonable compensation as W-2 wages for services performed. These wages are subject to Social Security and Medicare taxes (split between the corporation and the employee) and the Federal Unemployment Tax (and possibly state unemployment taxes).

Distinguishing Roles: Shareholder, Officer, Employee

The Internal Revenue Code states that an officer of an S corporation is considered an employee for Federal Unemployment Tax purposes. S corporations should not attempt to avoid this tax by treating officers’ compensation as distributions rather than wages.

Unreasonable Salaries and Employment Taxes

This issue has persisted for decades. In 1974, the IRS ruled that if a shareholder-employee doesn’t take a salary, or if it’s unreasonable, an auditor can reclassify distributions to account for reasonable compensation, assessing the related employment taxes and penalties. This includes the employee’s 6.2% Social Security and 1.45% Medicare payroll taxes, the S corporation’s matching amounts, and the Federal Unemployment Tax.

Who Is an Employee?

An officer of a corporation is generally considered an employee. Being a shareholder doesn’t change the requirement that any payments to an officer must be treated as wages. Courts have consistently ruled that S corporation shareholders who provide more than minor services to their corporation are employees whose compensation is subject to federal taxes. There’s an exception for officers who do not perform or perform only minor services.

What’s a Reasonable Salary?

According to Form 1120S instructions: “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.” There are no specific guidelines in the tax code for reasonable compensation. Courts base their decisions on the facts and circumstances of each case.

IRS Factors for Determining Reasonable Compensation

Factors considered by courts and the IRS when determining reasonable compensation include:

  • 👉 The officer’s training and experience
  • 👉 The officer’s duties and responsibilities
  • 👉 The time and effort devoted to the business
  • 👉 The corporation’s dividend history
  • 👉 Payments to non-shareholder employees
  • 👉 Timing and manner of bonuses paid to key people
  • 👉 Payments by comparable businesses for similar services
  • 👉 The corporation’s compensation agreements
  • 👉 Compensation formulas used by similar corporations

IRS Oversight and Challenges

The IRS often examines S corporations’ tax returns to ensure reasonable compensation is paid, especially when no compensation is paid to employee-stockholders.

The Pitfalls of Maximizing Deductions

Taxpayers can’t choose a compensation level to minimize taxes or maximize deductions without considering all factors related to reasonable compensation. Gathering the necessary data to support this can be complex and time-consuming. Some commercial firms have the resources to apply these factors properly, providing backup in case of an IRS challenge.

Get Expert Help with Employee Compensation for Your S Corp

Determining shareholder compensation can be tricky for S corporations. If you have questions about reasonable compensation for S corporation shareholders or its impact on your specific tax situation, call the experts at Insogna CPA. We’re here to help you navigate these complexities and ensure compliance.

If you need personalized advice or have specific questions, don’t hesitate to reach out to Insogna CPA. Let’s make sure your S corporation is in top shape for 2024!

Insogna CPA