S CorporationS Corporation shareholders who are also employees of the business are subject to special scrutiny.  One area of special scrutiny is the compensation and benefits paid to them. For any business operating as an S corporation, it’s important to ensure that shareholders involved in running the business are paid an amount that is commensurate with their workload.

What is reasonable for an S Corporation

This compensation must be reasonable based on the facts and circumstance for the type of work a shareholder-employee performs.  The IRS scrutinizes S corporations which distribute profits through cash distributions instead of paying wages subject to employment taxes.  Failing to pay an arm’s length compensation can lead not only to tax deficiencies, but penalties and interest on those deficiencies as well.

The Qualified Business Income Deduction under Section 199A, adds an additional layer of scrutiny over reasonable compensation paid to shareholder-employees.

As some background, S Corporations are hybrid entities that offer, among other attributes, taxation at the shareholder level.  The shareholder includes on their individual tax return their share of the business net income and loss distribution and compensation paid to them for their services to the company.

For clarification, an S Corporation has two types of distributions.

  • The first type is the net income or loss distribution.  The net profit or loss of the S Corporation is reported on a Schedule K-1.  Each shareholder reports this amount on their individual income tax return. The net income or loss distribution is an annual taxable event as part of the business entity tax return.  Under the current and prior tax law, this income is not subject to self-employment tax.
  • The second type is a cash (or property) distribution.  Anytime during the year, the S Corporation can issue payments to the shareholders as a return on their investment in the company.  The cash distribution(s), under most circumstances, is not a taxable event.

In addition, shareholders can receive other payments that originate from business operations; such as rent, expense reimbursement or loan repayments.

The balance of shareholder-employee compensation and return on investment creates the special scrutiny.  The key to establishing reasonable compensation is to research and determine compensation paid by other corporations for similar work performed by the shareholder-employee.  Identifying and documenting the facts and circumstances, then establishing the amount of reasonable compensation is extremely important.

If you are in this situation and want to discuss the salary you are being paid, please contact me.

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