S-Corporations offer a valuable tax benefit by allowing owners to take a portion of their profits as distributions not subject to self-employment tax. However, the IRS requires shareholder-employees to pay themselves a “reasonable” salary first. Misclassifying wages as distributions is a red flag that can lead to audits, penalties, and reclassification of income.
What Constitutes Reasonable Compensation?
The IRS defines it as the amount that would ordinarily be paid for similar services by similar businesses under similar circumstances. Considerations include:
- Duties and responsibilities
- Time devoted to the business
- Education and experience
- Prevailing industry wages
- Gross and net business income
Risks of Underpaying Salary
- The IRS can reclassify distributions as wages and assess back payroll taxes
- Late payroll tax deposits may incur penalties and interest
- You may lose credibility in future audits or tax disputes
Best Practices
- Base your salary on market data, not convenience
- Document your rationale with salary surveys, job descriptions, and performance metrics
- Pay yourself via payroll with W-2 reporting and withholdings
- Review compensation annually, especially as profits increase
Need help determining a defensible salary for your S-Corp? Contact us today.