S Corporations and the Need to Pay Reasonable Salaries

When you set up your business as an S corporation, you elect to have the earnings from the business taxed on the personal income tax returns of the shareholders. The S corporation files Form 1120S and reports the shareholders' shares of the income, deductions and credits on Schedules K-1. This effectively avoids double taxation - once on the corporate earnings and again on the distributions the shareholders receive from the S corporation.

As indicated by Joe Kristan in an article on IowaBiz, the earnings passed through to the shareholders on Schedule K-1 are subject to income tax but not social security and Medicare taxes. So shareholders who work in the S corporation could potentially avoid paying social security and Medicare taxes by paying themselves not with a salary, but through distributions from the S corporation. But as Kristan points out, the IRS does not allow this.

James A. Fellows and John F. Jewell, in an article for the Journal of Accountancy, warn that an S corporation that does not pay adequate salaries or any salary at all to the shareholder-employees is a red flag for an IRS audit. When a corporation elects subchapter S status, the IRS sends a notice reminding the shareholders that reasonable salaries must be paid to shareholder-employees. And the notice indicates that the IRS can reclassify distributions to the shareholders as salaries.

The question then becomes what is considered a reasonable salary. The IRS has not published specific criteria for determining a reasonable salary in specific industries. According to James A. Fellows and John F. Jewell, one option would be to pay the maximum amount subject to social security tax ($106,800 for 2011) for executive positions. Comparable salaries and wages for similar positions in the industry could be used for other shareholder-employees.

There are no hard and fast rules for determining a reasonable salary. The IRS provides some general guidance based on factors considered by courts in determining reasonable compensation. These factors include the person's training and experience, duties and responsibilities, the time and effort the person devotes to the business, what comparable businesses pay for similar services, payments to employees who are not shareholders, and the terms of compensation agreements.

The S corporation would have to withhold FICA taxes (social security and Medicare) from the shareholder-employees' salaries and wages. And as the employer, the S corporation would have to pay its corresponding share of the FICA taxes as well as federal and state unemployment taxes. The S corporation can claim a tax deduction for the salaries, wages and payroll taxes. This reduces the S corporation's net income available for distributions to shareholders.

The shareholder would pay income tax on the salary he or she receives and on the distributions of the S corporation's earnings after it deducts the salary and payroll tax expense. A positive aspect is that the shareholder receives social security credit for the salary received from the S corporation.

As suggested by William Perez in an article on About.com, businesses that are just starting out and that are not yet profitable may be advised not to form an S corporation until they are generating sufficient cash flow to be able to pay a reasonable salary to the owners.

Sources:

Form 1120S, U.S. Income Tax Return for an S Corporation

James A. Fellows and John F. Jewell, S Corporation Profits or Payday, Journal of Accountancy

Joe Kristan, S corporation salaries: how much is enough? IowaBiz

Schedule K-1 (Form 1120S), Shareholder's Share of Income, Deductions, Credits, etc.

Wage Compensation for S Corporation Officers, IRS

William Perez, Must S-Corporations really pay salaries to the owners? About.com