The IRS mandates that S corporation owners must pay themselves a salary that is reasonable in nature. The salary requirement is driven by the fact that S corporation income is not subject to self-employment tax and many S corporation owners have taken advantage of that fact by not paying themselves a salary or by paying a salary that is substantially lower than the net income generated by the S corporation. Although S corporations have been around for money years, it has become more of a focus for the IRS over recent years and will continue to grow in importance until the IRS provides specific guidance on the amount of compensation that must be paid. Until that guidance is provided there are a few things to keep in mind for S corporation owners:

1. If you are an officer of the corporation you are generally considered to be an employee. If payments are being made to an officer or shareholder, the IRS typically considers the payments to be wages. Courts have consistently held that S corporation officers/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payments are employees whose compensation is subject to federal employment taxes.

2. 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, but if cash or the right to receive cash went to the shareholder then a salary level must be determined.

3. Factors that are used by the IRS for determining reasonable compensation include training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, what comparable businesses pay for similar services, and the use of a formula to determine compensation.

Again, there is no specific guideline for determining reasonable compensation, but consideration should be given to any amounts received by an officer/shareholder. S corporation owners should take advantage of the opportunity, with three months left in the year, to consult their tax advisors and begin the process of determining what level of salary should be paid. Don’t leave the door open for IRS scrutiny.