Reasonable compensation for S-Corp Owners
Who must be paid reasonable compensation? Generally, an officer of an S corporation who performs substantial services and receives, or is entitled to receive, compensation in any form is considered an employee whose compensation is subject to federal employment taxes. The IRS and courts have consistently held that S corporation shareholder-employees who provide more than minor services must receive reasonable compensation.
There is no straightforward rule or safe harbor in the Internal Revenue Code for what constitutes reasonable compensation. Instead, courts have developed a multifactor approach, considering all facts and circumstances. The following factors are commonly considered but no single factor is determinative.
Employee’s Qualifications: Education, experience, and special skills.
Nature, Extent, and Scope of Work: Duties performed, hours worked, and the importance of the role.
Size and Complexity of the Business: Larger, more complex businesses may justify higher compensation.
Comparison with Salaries Paid by Similar Companies: Benchmarking against industry standards for similar roles.
Company’s Gross and Net Income: The financial performance of the business.
Comparison with Distributions to Shareholders: If compensation is low and distributions are high, the IRS may recharacterize distributions as wages.
Prevailing Rates for Comparable Positions: What similar businesses pay for similar services.
Salary Policy for All Employees: Consistency in compensation practices.
Determining reasonable compensation for an S corporation owner is a complex and fact-intensive process. The issue is significant because S corporation shareholder-employees may have incentives to minimize their reported compensation to reduce payroll taxes and maximize the qualified business income (QBI). However, the IRS requires that S corporation shareholder-employees who provide substantial services to the corporation receive reasonable compensation, which is subject to employment taxes and is excluded from QBI.