S corporation reasonable compensation

This one is on the desk because the owner's salary is the one number on an S corporation return that should never be a guess, and too often is.

Your S corporation will clear $400,000 this year before it pays you. Every dollar you take as wages carries 15.3 percent in Social Security and Medicare tax, split between you and the company, up to the 2026 wage base of $184,500. A distribution carries none. On that business, the difference between a $60,000 salary and a $150,000 salary is $13,770 a year in payroll tax. That gap is the reason the strategy exists, and the reason the salary has to be a number you can defend.

What counts as reasonable compensation for an S corp owner?

A corporate officer is an employee for payroll tax purposes: Section 3121(d)(1) covers "any officer of a corporation." If you perform more than minor services and take money out of the company, part of that money is a salary.

The Code does not set the figure. The rule comes from the definition of wages in Section 3121(a), "all remuneration for employment," and from Rev. Rul. 74-44, in which the IRS treated "dividends" paid to two shareholder employees who drew no salary as wages. The label does not matter: "The name by which the remuneration for employment is designated is immaterial" (Treas. Reg. §31.3121(a)-1(c)).

The most useful frame is the IRS's own. Its guidance divides gross receipts by source: the shareholder's personal services, the services of nonshareholder employees, and capital and equipment. Profit produced by staff and capital may properly leave as distributions. Profit produced by the owner's own work is compensation. A consultant who bills every hour personally has a salary close to the profit. An owner whose fifteen employees produce most of the revenue does not.

How does the IRS decide whether an S corp salary is too low?

The IRS lists the factors courts have used: training and experience; duties and responsibilities; time and effort devoted to the business; dividend history; payments to nonshareholder employees; the timing and manner of bonuses to key people; what comparable businesses pay for similar services; compensation agreements; and the use of a formula.

Three carry most cases. Duties and time: what the owner does, and for how many hours. Comparable pay: what the market would pay someone else for that job in that region. Distributions relative to salary: a small salary beside large distributions is evidence in itself, because the company had the cash for wages and chose not to pay them.

A defensible file holds each in writing: a job description, an estimate of hours, published wage data for the role and region, the split of gross receipts among the three sources, and a written resolution setting the salary before payroll runs. It is what an examiner asks for, and what we review with the business owners we serve each fall.

What happens when an S corp salary is too low?

The reported cases are consistent, and the owners lost them on the facts.

In David E. Watson, P.C. v. United States, a CPA with a master's degree in taxation and nearly twenty years of experience held his 25 percent interest in an accounting firm through his own S corporation. It paid him a $24,000 salary and distributed $203,651 in 2002 and $175,470 in 2003. The government's expert, using regional survey data on accounting firm pay, valued his services at $91,044 a year. The district court adopted that figure, and the Eighth Circuit affirmed in February 2012. The company's intent to pay only $24,000 did not control. The payments were remuneration for services.

In Glass Blocks Unlimited v. Commissioner, the president was the company's only full time worker. It paid him no wages, only distributions and purported repayments of shareholder loans with no note, interest or repayment schedule. It argued he worked about 1,040 hours a year at $15.25 an hour. The Tax Court found more than 2,080 hours, so at the company's own rate his services were worth more than everything it paid him, and the full amount was wages.

The Seventh and Ninth Circuits reached the same result in 1990, in Joseph Radtke, S.C. and Spicer Accounting. The pattern: a token or zero salary, distributions that tracked the owner's own work, and no file.

Why set the S corp salary in the fall instead of at filing?

Because wages count when paid. Under Treas. Reg. §31.3121(a)-2(a), wages are received "at the time that they are paid by the employer to the employee." A 2026 salary has to run through 2026 payroll.

In October the year is still open. The owner can see three quarters of profit, compare the salary paid so far with the file, and run the balance through fourth quarter payroll with withholding deposited on time. The W-2 and the quarterly Forms 941 then agree.

At filing in March, the year is closed. A payment made then is a 2027 wage. Changing 2026 means reclassifying distributions already paid: amended payroll returns, corrected W-2s, interest and possibly penalties. Most owners leave the number alone, and the exposure stays on the return.

The fall review also settles what depends on the salary: retirement plan contributions are computed on W-2 pay, and under Section 199A, W-2 wages set the wage limit on the deduction. Above the 2026 wage base, each further dollar of salary costs 2.9 percent in Medicare tax rather than 15.3 percent, plus the 0.9 percent Additional Medicare Tax on wages over $200,000. We do not propose a strategy until we can tell you what you owe, which is why the salary is set against a projection, not a habit.

A worked example

The figures are illustrative and rounded.

• The S corporation will earn $400,000 before the owner's pay. The owner runs sales and operations about fifty hours a week; five employees deliver most of the work.
• The file (duties, hours, regional wage data for an operations executive) supports $150,000.
• Through September the owner has been paid $5,000 a month, or $45,000.

Left alone, the year ends at $60,000: $60,000 × 15.3% = $9,180 in payroll tax.

Corrected in October, fourth quarter payroll carries $105,000 and the year ends at $150,000: $150,000 × 15.3% = $22,950.

The difference is $13,770, before the corporation's deduction for its half. That is the price of the defensible number, and the other $250,000 still leaves as distributions free of payroll tax. If the owner leaves the salary at $60,000 and an examiner later sustains $150,000, as the court did on similar reasoning in Watson, the $13,770 would be assessed for a closed year, with interest, and penalties may follow.

The authority

For the position:

• Internal Revenue Code §3121(a). A return on capital, or on other employees' work, is not remuneration for the owner's services.
• IRS, S corporation compensation and medical insurance issues (guidance, not precedent).

The rule and its timing:

• Internal Revenue Code §3121(d)(1); Treas. Reg. §§31.3121(a)-1(c) and 31.3121(a)-2(a).
• Rev. Rul. 74-44, 1974-1 C.B. 287.

Against the position, where the salary is unsupported:

• David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012).
• Glass Blocks Unlimited v. Commissioner, T.C. Memo. 2013-180.
• Spicer Accounting, Inc. v. United States, 918 F.2d 90 (9th Cir. 1990).
• Joseph Radtke, S.C. v. United States, 895 F.2d 1196 (7th Cir. 1990).

Verdict: Sound, when documented

An owner who pays a salary supported by duties, hours and market data, and distributes the rest, stands on the definition of wages and the IRS's own framework. The verdict moves to Avoid if distributions are paid while the salary is zero, if the figure is a rule of thumb chosen at filing, or if shareholder "loans" stand in for wages. It moves to Conditional when the business has no staff and little capital, because nearly all of the profit is then compensation.

FAQ

Is there a safe percentage, such as 60/40? No. No Code section, regulation or ruling sets a ratio of salary to distributions. The courts ask what the owner's services are worth, and that answer comes from duties, hours and comparable pay.

Can I skip salary in a year the company loses money? The exposure follows the payments. If the company pays you nothing, there is nothing to recharacterize. If it pays distributions or loan repayments while you work full time, Glass Blocks shows they can be wages even when income is modest.

Does a higher salary help anywhere? It can. W-2 pay is the base for retirement plan contributions and the Section 199A wage limit. The fall review weighs both against the payroll tax, as part of our planning work.

This review is general information about the law as it stands on the date of publication. Whether a strategy fits depends on facts we have not seen. If you are weighing it, an introductory call costs nothing and commits you to nothing.

For tax professionals: if a client has brought you this strategy, or should have, we will review it with you and report back. You keep the client.

Ryan Munoz, EA, is the founder of Trinity Tax Strategies.

Trinity Tax Strategies, LLC does not provide investment advice and does not sell securities or insurance. Ryan Munoz is also a licensed financial advisor with a separately registered investment adviser, and that firm and Trinity are affiliated through him. Advisory and insurance services are provided by separately licensed firms and professionals under their own agreements. This article is general information, not tax, legal or investment advice.