What's "Reasonable Compensation" for S Corp Owners?

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."

Reasonable Compensation is the amount S corporations must pay a shareholder-employee, aka Owner Operator, in return for services that the shareholder-employee provides to the business before non-wage distributions (Shareholder Distributions: 'draws from the business account') may be made to the shareholder-employee. Also, the amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.

The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation by looking to the source of the S corporation's gross receipts.

The three major sources are:

  1. Services of shareholder

  2. Services of non-shareholder employees or

  3. Capital and equipment

In addition to gross receipts generated directly by the shareholder-employee, the shareholder-employee should also be subject to wage treatment for administrative work performed by him for the other income-producing employees or assets. For example, a manager may not directly produce gross receipts, but he assists the other employees or assets which are producing the day-to-day gross receipts.

Some factors 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

To the extent gross receipts are generated by services of non-shareholder employees and capital and equipment, payments to the shareholder would properly be treated as non-wage distributions that are not subject to employment taxes.

But to the extent gross receipts are generated by the shareholder's personal services, then payments to the shareholder-employee should be classified as wages that are subject to employment taxes.

The IRS has the authority to reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes). Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which are subject to employment taxes.

Authority to Reclassify

Joly v. Commissioner, T.C. Memo. 1998-361, aff'd by unpub. op., 211 F.3d 1269 (6th Cir. 2000)

Reinforced Employment Status of Shareholders

Veterinary Surgical Consultants, P.C. vs. Commissioner, 117 T.C. 141 (2001)

Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 (2002)

Reasonable Reimbursement for Services Performed

David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. 2012)

Source: https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues#Reasonable%20Compensation

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