Reasonable Compensation for S Corporation Shareholder-Employees
S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.
In recent years, many S corporations have come under IRS scrutiny regarding this issue. 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. If shareholder distributions are reclassified as wages, employment taxes and penalties are assessed.
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 which are:
Services of shareholder
Services of non-shareholder employees or
Capital and equipment
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.
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
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
The use of a formula to determine compensation