This is the HOTTEST topic for S Corporations and where I can help. I can determine exactly what a reasonable wage for your business is so you avoid this trap.  Do not put his off.

Compensation Issues Involving S Corporation Shareholders

A. Compensation of shareholder-employees is a major tax planning and compliance area for closely-held corporations.

B.  In respect of an S corporation, there are two circumstances where compensation is an issue:

  1. First, a family S corporation, where one person has given stock to family members, could be used to shift earned income from the primary earner to other family members.
  1. Secondly, there is no self-employment income of S corporations.
  1. Therefore, shareholders are not liable for any self-employment tax on a shareholder’s portion of an S corporation’s profits.
  1. The catch is that an S corporation and its employees are subject to all payroll-related taxes on compensation.
  1. Any officer of a corporation that performs services is defined as an employee by statute for federal employment tax purposes, as well as for most local employment situations (whether a shareholder or not).

C. What is the problem with recharacterizing wages as a distribution?

  1. The recharacterization would affect only the shareholder who received the compensation. If there are other shareholders, the distribution would not be proportionate to all shares of stock, possibly causing a second class of stock (If this happens the S Corporation status could be revoked resulting in the corporation being a C Corporation).
  1. Another question is whether or not the excessively compensated shareholder has basis for a tax-free distribution.

D. Insufficient (low or no) compensation is addressed in two S corporation areas as follows:

  1. First, family S corporations where family income shifting is possible.
  1. Code Section 1366(e) states that a family member who provides services or capital to the corporation must receive reasonable compensation to prevent the S corporation’s income from being reallocated among family members
  1. Along with shifting income to other family members with lower tax brackets, the S corporation is used to keep earnings at a level so a taxpayer will not suffer a reduction in Social Security benefits.
  1. Secondly, as stated above, no self-employment income passes from an S corporation to its shareholders, causing tax professionals to attempt to use this provision to avoid Social Security and other payroll taxes.
  1. For this scenario to work, the corporation must not make any distributions, as they can be recharacterized as wages (Revenue Ruling 74-44).
  1. Revenue Ruling 74-44 held that distributions were in fact a disguised form of compensation.
  1. The attitude of the IRS has changed. In 1989, the IRS prevailed in the case of Radtke, and in 1990, the IRS was successful in two cases, Spicer Accounting, Inc. vs. U.S., and Esser vs. U.S. In all three cases, the IRS prevailed in converting the entire distribution to salaries
  1. Deficiency notices reclassifying distributions as wages create the following deficiencies:
  1. Federal withholding tax equal to 28% of the total distribution.
  1. FICA taxes, both the employer and employee share, which total in excess of 15% of the distribution (to the limitation).
  1. FUTA taxes equal to 6.2% of the first $7,000 of the distribution.
  1. Penalties for not filing the payroll tax returns: Section 6651 – 5% penalty for each month late, up to 25%; Section 6656 – 10% for failure to deposit payroll taxes.


28.00% – Income tax withholding

15.30% – FICA taxes

6.20% –   FUTA taxes·

49.50% – Withholding penalty and interest

NOTE – When an S corporation is assessed payroll taxes for unreported compensation, the resulting penalties and interest will be significantly greater than in an income deficiency assessment. The S corporation will typically have violated the quarterly payroll deposit rules, causing penalties that include failure to timely deposit and failure to properly report.

  1. Service to Increase Focus on Unreasonably Low Compensation for S Corporation Owners This report, entitled “Final Audit Report – The Internal Revenue Service does not always address subchapter S Corporation officer compensation during examinations (Audit #200230125),” was prepared by Ms. Pamela Gardiner, IRS Deputy Inspector General for Audit, and was submitted to the Commissioner, Small Business/Self-Employed Division.

NOTE: The report was prepared June 2005, but was just cleared recently for public disclosure by the Treasury Inspector General for Tax Administration with any information determined to be restricted from public release being redacted from the document. So, the topic has been very much in the forefront of the IRS’s list of pertinent items to be queried upon audit. These examinations of S corporations are becoming more prevalent around the country.

  1. The Service’s intent is to target those instances where an S corp. owner/employee will take a low salary while receiving most of the company’s profits as a distribution.

NOTE: The Service was roundly criticized for not being more diligent on this issue in its examinations of S corporations. Another issue found to be ignored was the possible misuse of certain fringe benefits, such as the personal use of company cars, reimbursed personal expenses, and payments made under what were to be considered nonaccountable plans.

  1. Treasury report signals new IRS crackdown on low compensation of S owner employees [Treasury Inspector General for Tax Administration (TIOTA) Audit #200230123].
  1. The only taxpayer victory I know is the Davis Case. The Davis case states that the IRS does not have a unilateral right to reclassify distributions to S shareholders as wages. Instead, only that portion of any distribution that represents reasonable compensation for the work done can be treated as wages.

SUMMARY – With external sources to get comparative salary information, it is very important to looking into these sources and compare salaries.  Some of these sources include:

  • Robert Half & Assocates
  • Bureau of Labor Statistics

FACT SHEET 2008-25

Wage Compensation for S Corporation Officers

FS-2008-25, August 2008

Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code. When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages. Subchapter S corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders.

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow through of income and losses on their personal tax returns and are assessed tax at their individual income – tax rates.

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.

This fact sheet clarifies information that small business taxpayers should understand regarding the tax ~ law for corporate officers who perform services.

Who’s an employee of the corporation?

Generally, an officer of a corporation is an employee of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. Courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes.

The Treasury Regulations provide an exception for an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration. Such an officer would not be considered an employee.

What’s a Reasonable Salary?

The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “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.”

The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. However, if cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.

There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

Some factors considered by the courts in determining reasonable compensation:

  • 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

Medical Insurance Premiums treated as wages.  NOTE – the below has changed quite a bit since Obamacare and will I will be updating in the near future.

The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUT A) taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2.

A 2-percent shareholder-employee is eligible for an AGI deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation. Previously, “established by the S corporation” meant that the medical care coverage had to be in the name of the S corporation.

In Notice 2008-1, the IRS stated that if the medical coverage plan is in the name of the 2 percent shareholder and not in the name of the S corporation, a medical care plan can be considered to be established by the S corporation if: the S corporation either paid or reimbursed the 2 percent shareholder for the premiums and reported the premium payment or reimbursement as wages on the 2 percent shareholder’s Form W-2.

Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of the Form W-2.

Schedule K-l (Form 1120S) and Form 1099 should not be used as an alternative to the Form W-2 to report this additional compensation.