S Corp Salary Guidelines – What is Reasonable Compensation?

Can you help your S Corp clients determine reasonable compensation? With the S Corp deadline in March, here’s what your clients need to know to stay on the safe side of the Internal Revenue Service (IRS).

What is an S Corp?

S Corps are corporations that elect to pass through their corporate income, losses, deductions, and credits to their shareholders for federal tax purposes. S Corp shareholders then report income and losses on their personal tax returns and are taxed at their income tax rates. LLC and C Corp owners choose the S Corp structure to avoid double taxation on business income. March 15 is the deadline to elect S Corp status.

A corporation must meet the following conditions to qualify for S Corp status:

  • Be a national company
  • Have only authorized shareholders:
    • These can be individuals, certain trusts and estates and cannot be partnerships, corporations or non-resident foreign shareholders
  • Have no more than 100 shareholders
  • Have a single stock class

An S Corp is not a legal business entity on its own. Rather, the S Corp designation is a special choice made by an LLC or C Corp with the IRS that allows the business to offer the same liability protection as corporations and LLCs, protecting owners’ personal assets from company debts and lawsuits.

The S Corp Advantage

In addition to liability protection and avoidance of double taxation, S Corps have other advantages:

  • They are only required to file a tax return once a year
  • They can sell shares and
  • They have perpetual existence, meaning the business continues to exist even if the owner leaves or dies.

The S Corp is also a popular entity election because it allows the owner(s) to divide the company’s income into salaries and distributions. Owners pay payroll taxes on salaries only, not on distributions to shareholders. Dividends are distributions of business income in the form of return of capital to a shareholder and are not subject to payroll taxes. For this reason, the IRS closely monitors an S Corp’s dividend distributions to make sure the company isn’t simply trying to avoid paying employment taxes.

What is reasonable remuneration?

It can get messy if the IRS thinks owners are trying to hide salaries behind distributions to avoid paying payroll taxes. S Corp owners must pay “reasonable compensation” to each shareholder/employee in exchange for any service provided by the shareholder-employee. Defined by the IRS, “reasonable compensation is the value that would ordinarily be paid for similar services by like businesses in like circumstances.” Generally, if a shareholder does anything other than contribute money to the business, the shareholder is considered an employee. If so, the shareholder should receive salaries comparable to similar services paid for similar industries.

The definition of an employee for payroll tax purposes—FICA, FUTA, and federal income tax withholding—includes corporate officers and shareholders, if and when services are rendered to the company. Courts have consistently held that S Corp owners/managers/shareholders who work and provide more than minimal services to the company are liable to receive wages, wages subject to federal employment taxes.

Although the definition of what constitutes a “reasonable” salary may seem subjective, the IRS examines the S Corp’s source of income – its gross receipts – and then determines whether (and what tasks) the owner/shareholder has performed for the S Corp to help generate gross receipts.

Any portion of gross revenue generated either by shareholder involvement or by assisting employees to provide services must be remunerated in the form of salary and subject to employment taxes. The IRS recommends considering the following factors in determining the reasonableness of compensation:

  • Duties performed by the employee
  • The volume of business handled
  • The character and degree of responsibility
  • The complexity of your business
  • The required time
  • Local cost of living
  • The ability and accomplishments of the individual employee performing the service
  • Salary compared to the company’s gross and net income, as well as distributions to shareholders if the company is a corporation
  • Your policy regarding wages for all employees
  • The salary history of each employee

The U.S. Bureau of Labor Statistics compiles comprehensive salary data searchable by occupation nationwide, in addition to comparable salaries by state, region, and city.

Application for S Corp Status

To be treated as an S Corp, a corporation or LLC must complete and file IRS Form 2553 no later than two months and 15 days after the start of the tax year. S Corp status will begin the following calendar year if your company does not meet the deadline.

An S Corp must file its annual tax return no later than the 15th day of the third month following the end of the tax year, which is March 15 (unless the 15th falls on a weekend or holiday). All financial activities must be filed on Form 1120S, along with a Schedule K-1 for each shareholder. Make sure clients include detailed documentation for each shareholder to substantiate any concerns about salaries versus dividends. Documentation should describe the type of work and number of hours worked by the shareholder, with comparable wages in similar positions as evidence of reasonable compensation.


Nellie Akalp is a passionate entrepreneur, business expert and mother of four. She is CEO ofCorpNet.com, a trusted resource and service provider for business incorporation, LLC filings, and corporate compliance services in all 50 states. Akalp and his team recently launched a partnership program for accountants, lawyers and business professionals to help them streamline the incorporation and compliance process for their clients.

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