S Corporation Reasonable Compensation: A Year-End Checklist for Owner Salaries

S corporation reasonable compensation is the wage an S corporation must pay a shareholder-employee for the services he performs before it makes non-wage distributions to him. The IRS states the rule plainly, courts decide the amount on the facts of each case, and the officer who performs only minor services and takes no pay is the narrow exception. This checklist is for CPAs and EAs who review owner salaries for S corporation clients in the fourth quarter.

The timing matters because payroll for the year is still open. In practice, a short salary is easiest to fix in the December payrolls. After year-end, a fix for this year usually means amended payroll filings. And the exposure is real: the IRS says it "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)."

What Does the IRS Say About S Corporation Reasonable Compensation?

The IRS position is that wages come first. Its page on S corporation compensation and medical insurance issues says: "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 same page quotes the Form 1120-S instructions: "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." It also sets a ceiling that clients often miss: "The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly." A shareholder who received nothing, directly or indirectly, has no wage to reclassify.

The older source is still the clearest. Fact Sheet FS-2008-25, "Wage Compensation for S Corporation Officers," opens with the employment tax point:

Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code.

It adds that "S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages."

The exception is narrow. Treas. Reg. 31.3121(d)-1(b) provides that "an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation." Both halves must hold. An officer who performs minor services but is paid for them does not fit the exception.

The IRS page lists four court cases in support, including David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. 2012), under the row "Reasonable Reimbursement for Services Performed." Read the opinions before you cite any of them. I list them here only as the IRS does.

How Is Reasonable Compensation Judged?

No formula exists. FS-2008-25 says: "There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case."

The fact sheet then lists "some factors considered by the courts in determining reasonable compensation," and the IRS page repeats the same nine:

• 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

The IRS page adds a second lens that I find more useful in practice. "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." It names three sources: services of the shareholder, services of non-shareholder employees, and capital and equipment. Receipts from the shareholder's personal services point to wages. Receipts from employees and equipment can support distributions. The page also says administrative work counts: "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."

There is one more document you will see quoted, and it needs a label. The Reasonable Compensation Job Aid for IRS Valuation Professionals (October 29, 2014) is an internal IRS reference, not authority. It says so in the header of its pages: "This Job Aid is not Official IRS position and was prepared for reference purposes only; it may not be used or cited as authority for setting any legal position."

It is still worth reading, because it shows how an IRS valuation analyst approaches the question. It describes "the market approach, which is the most commonly used method; the income approach; and, finally, the least used method, the cost approach." The market approach asks: "How much compensation would be paid for this same position, held by a non-owner in an arms-length employment relationship, at a similar company?" The income approach rests on an "Independent Investor Test," and the cost approach prices the owner's duties one function at a time.

The Job Aid also separates two problems. Usually the issue is whether pay is reasonable "so that it is deductible under section 162." In some cases it arises "when the amount of compensation paid may be lower than reasonable to avoid the payment of employment taxes." The S corporation owner-salary review is the second problem.

The Year-End Reasonable Compensation Checklist

Work through this for each shareholder who is also an officer or performs services.

1. Confirm status. List each shareholder's officer title and the services he actually performs. Apply the Treas. Reg. 31.3121(d)-1(b) exception only if he performs no services or only minor services and receives no remuneration.
2. Total what went out. Pull year-to-date wages, distributions, shareholder loans, and corporate payments of personal expenses. FS-2008-25 names all of these as payments that should not substitute for wages.
3. Map gross receipts. Split the year's receipts among the three sources on the IRS page. Write down the basis for the split.
4. Walk the nine factors. Write one or two sentences on each. A blank line on "time and effort devoted to the business" is a gap an examiner will fill for you.
5. Get comparable pay data. "What comparable businesses pay for similar services" is a court factor. Save the survey or source you used, with its date.
6. Check health premiums for more-than-2% shareholders. The IRS page says these premiums escape FICA and FUTA if paid "under a plan or system that makes provision for all or a class of employees (or employees and their dependents)," and then the additional compensation "is included in the shareholder-employee's Box 1 (Wages) of Form W-2, Wage and Tax Statement, but is not included in Boxes 3 and 5 of Form W-2." FS-2008-25 adds that "Schedule K-1 (Form 1120S) and Form 1099 should not be used as an alternative to the Form W-2 to report this additional compensation." Get the premiums into payroll before the last run.
7. Set the number and run it. If wages are short, increase them in the remaining December payrolls.
8. Paper the decision. Record the salary in a compensation agreement or board minutes, since both "compensation agreements" and "the use of a formula" appear in the factor list. Then write a short memo to file. The structure in my post on writing a tax research memo works for this.

What Are the Most Common Reasonable Compensation Mistakes?

The most expensive mistake is zero salary with regular distributions to an owner who runs the business. FS-2008-25 says "Courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes." A zero-wage position for that owner conflicts with the IRS guidance on its face.

The other common mistakes, each measured against the sources:

• Loans and expense payments in place of wages. The fact sheet names them directly.
• Reading the minor-services exception as a planning tool. The regulation also requires that the officer receive no remuneration.
• Ignoring administrative work. An owner who manages producing employees still performs services, by the IRS page's own example.
• A salary with no recorded basis. With no bright-line rule, the facts you wrote down are the support you have.

How Does Reasonable Compensation Interact With the Section 199A Deduction?

Reasonable compensation is excluded from qualified business income, and the S corporation's deduction for it reduces QBI when properly allocable to that business. Treas. Reg. 1.199A-3(b)(2)(ii)(H) lists "Reasonable compensation received by a shareholder from an S corporation" among items not taken into account, then adds: "However, the S corporation's deduction for such reasonable compensation will reduce QBI if such deduction is properly allocable to the trade or business and is otherwise deductible for Federal income tax purposes."

So a higher deductible salary means lower QBI from that business, other things equal. Some clients will want to use that to argue for a lower salary. Do not let the QBI result set the wage. The wage answers to the facts and the factors above. My Section 199A walkthrough covers the rest of the computation.

What to Do With the Results

Each review ends one of three ways.

If the salary is supported, put the memo and the comparable data in the permanent file and move on.

If it is short, fix it now, through payroll, while December runs remain. Tell the client why in writing and keep a copy.

If the facts are unclear, say so. Record what you know, what you could not confirm, and the client's decision. A file that shows the question was asked is better than a file that is silent.

I built Tax Orator because this kind of work means pulling a fact sheet, an IRS web page, two regulations, and an internal job aid, then reading each one closely enough to quote it. Every source I quote above is an IRS or Treasury document you can read yourself.

Frequently Asked Questions

Can an S corporation officer take distributions and no salary? Not if the officer performs more than minor services and receives payments. FS-2008-25 says courts have consistently held such officer/shareholders are employees whose compensation is subject to federal employment taxes. The regulation's exception also requires that the officer neither receive nor be entitled to receive any remuneration.

Can I cite the IRS Reasonable Compensation Job Aid as authority? No. The Job Aid states that it is not an official IRS position and "may not be used or cited as authority for setting any legal position."