S Corporation

Do S Corporations need to pay salaries to owners who work in the business?

Learn why S corporations should pay a salary to owners who work in the business, and how to arrive at a reasonable salary.

An owner who also works in the business is considered an employee and as such any payments for services to that owner is wages and subject to employment tax. This is settled law; the IRS tax code is clear about that, and the courts have ruled in favor of the IRS when challenged on this matter. It is clear that owners who provide services to an S corporation are employees and employment taxes are to be paid on their earnings up to a reasonable amount. What is less clear is how to determine a reasonable amount.

What is a reasonable salary for an S corporation owner who works in the business?

The standard for reasonable compensation is what the person would earn if he or she worked for a similar but independent business. This question arises if the IRS audits your S corporation to determine if payments to owners of the business were properly classified. The choice to audit a particular S corporation can be made randomly, but if officer compensation (line 7 on the 1120S return) is zero or is very small in relation to the overall business profit, the S corporation has an increased chance of being audited.

Factors to consider when determining a reasonable salary

In an audit situation, the IRS will use the following factors to arrive at the compensation they consider reasonable for the officers of the S corporation:

* Training and experience

* Duties and responsibilities

* Time devoted to the business

* Earnings of non-owner employees

* What similar businesses pay for comparable work

* How much was actually paid to or on behalf of the owner - personal expenses paid on behalf of the owner will be considered wages subject to employment tax. On the other hand if the actual payments are less than what is considered a reasonable salary, the actual payment would be the salary.

* How much was available to pay salaries – the business would not be required to pay more than it can afford. If the S corporation suffered a loss, it is not required to pay salaries to the officers.

This caution is primarily for businesses with large profits but little or no officer compensation. It is a common belief among S corporation owners that they do not need to take a salary, but the law does not support that, and the IRS is targeting S corporations that do not pay reasonable compensation to officers. We encourage you to take a look at what the IRS says about, “Wage Compensation for S Corporation Officers” and avoid the bother of an audit. Contact us at 305-595-2886 or verna@jamesaccounting.com to help you determine reasonable officer salaries and other policies related to S corporations