Thigpen, Jones, Seaton, & Co

Shareholder Compensation

By Becky G. Hines, CPA, CFE on October 7th, 2011

Most S corporation shareholders would rather take a dividend distribution from their S corporations’ profits instead of compensation payments to avoid Social Security and Medicare taxes.  To prevent this avoidance of payroll taxes, the IRS requires that S corporations pay a reasonable salary to its shareholders who perform substantial services.

The Internal Revenue Service does not provide a definition of “reasonable compensation” in its Code or Regulations, however, various court rulings on the issue have considered the following factors in their determination of “reasonableness”:

• Training, experience, duties and responsibilities – The greater the experience, responsibilities, and effort of the shareholder, the larger the salary should be.
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
  If a shareholder has more responsibilities than the highest paid non-shareholder employee, the shareholder’s compensation should generally be higher than the non-shareholder employee

• What comparable businesses pay for similar services
  Benchmarking tools from sources such as monster.com, salary. com, Robert Half, and Bureau of Labor Statistics wage data can help in determining the reasonableness of a shareholder‘s salary when compared with industry norms.

• Company conditions
• Comparisons with prior years
  If the corporation has had rising revenues, but the shareholder’s salary has not changed, this may be a sign that the salary is unreasonable. If the company recently elected S status and also reduced its amount of shareholder salary, this will raise questions about whether the driving force behind the salary reduction was to avoid payroll taxes.

• Compensation compared with distributions
  While large distributions together with a small salary may increase the likelihood of an IRS examination, there is no requirement that an S corporation pay out all profits as compensation.  If a shareholder withdraws $110,000 in distributions and is paid $70,000 in compensation, the IRS may recharacterize enough distribution to make sure the shareholder’s compensation equals or exceeds the Social Security wage base for the year in question (currently $106,000 in 2011).  If the salary equals or exceeds that wage base, the tax savings of the salary versus distributions diminish greatly which would more than likely reduce the risk of an IRS challenge.

• Compensation as a percentage of corporate sales or profits
  Financial ratios published in industry-specific publications can help determine the corporation’s overall profitability and the shareholder’s compensation as a percentage of sales or profits.  If the resulting ratios indicate that the S corporation is more profitable than its peers but is paying less salary to the shareholder, a determination should be made to justify the lower salary.  If no determination can be made, an increase in compensation to the industry and geographic norms provided for in the publications will probably be necessary.

What is an unreasonable salary?  Zero salary is unreasonable since no one works for free.  A salary below minimum wage is unreasonable.  A non-shareholder would not accept a job for less than minimum wage.  A salary that is far in excess of an appropriate wage is unreasonable.  Paying a $600,000 salary when an officer in the similar position only makes $80,000 is also unreasonable.

S corporation officer compensation is a hot issue with the Internal Revenue Service. The IRS can assess payroll taxes and reclass distributions as compensation if they determine that the current compensation is unreasonable.  The penalty for failing to pay payroll taxes is 100% of the taxes owed.  S corporations can avoid this payroll tax penalty by paying shareholder-employees a reasonable salary.

If you have any questions about this topic, please contact us and we will be glad to help.

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