There are many ways to financially reward an employee and an investor. In most cases, S Corporation shareholders fill both roles. It is important for the S Corporation to properly allocate wages, fringe benefits and distributions of profits, and documentation of how the allocation was determined is necessary.
If a shareholder of an S Corporation provides more than minor services to the corporation and should or does receive payment, then they are an employee whose compensation is subject to federal employment tax.
Now arises the issue of reasonable compensation for officer wages. The IRS requires S Corporation shareholder-employees and officers to take reasonable wages. However, there is no clear definition of reasonable compensation.
Reasonable compensation then becomes determined by the facts and circumstances of the given situation. Some things that factor in the determination of reasonable compensation include: training and experience, duties and responsibilities, time and effort, or compensation agreements.
Depending on these factors, a shareholder-employee could be due substantial wages, potentially exceeding their distributions, or significantly less than their distributions; it really just depends.
S Corporations should never attempt to avoid paying employment taxes by falsifying a shareholder’s involvement or contributions to the corporation. Some S Corporations pay large dividends or provide excessive fringe benefits to shareholder-employees, and this is a great way to end up in trouble with the IRS.
Keep in mind it isn’t unreasonable for shareholder-employees to take low or no wages during start-up years, if the company isn’t producing sufficient funds to be able to reasonably compensate the shareholder, but this is one of the only exceptions to the reasonable compensation rule.
The Wassman CPA Services website and blog is meant to offer general information to our readers. The information provided is not intended to replace or serve as a substitute for any accounting, tax or other professional advice, consultation or service. You should contact Wassman CPA Services for advice concerning specific matters prior to making any decisions.
