Why This Conversation Cannot Wait Until Tax Season
Updated: Aug 6
The S corporation strategy is not simply, “Pay yourself a small salary and take everything else as distributions.” Popular internet advice is still not a substitute for a defensible compensation analysis.
Electing S corporation status can create significant tax savings for a profitable business owner. However, it can also lead to payroll problems, retirement-plan limitations, inaccurate financial statements, and uncomfortable conversations with the IRS when shareholder compensation is treated as an afterthought.
An S corporation shareholder who performs services for the business generally wears two different hats:
An employee who should receive reasonable compensation for services performed.
An owner who may receive distributions representing a return on the investment in the business.
Determining how much belongs in each category requires more than selecting a convenient number. It requires ongoing discussions with your tax advisor based on your actual activities, how the business earns its revenue, and how the compensation decision affects the rest of your tax plan.
Why Salary and Distributions Are Treated Differently
Salary paid to a shareholder-employee is subject to payroll taxes, including Social Security and Medicare taxes. The corporation generally deducts the salary and its share of applicable payroll taxes, while the shareholder reports the wages on Form W-2.
A shareholder distribution is different. It is generally not subject to payroll taxes, although it may have income tax consequences if the shareholder does not have sufficient basis or if other special rules apply.
That payroll tax difference creates the temptation to minimize wages and maximize distributions. The IRS is fully aware of that temptation. Its position is straightforward: An S corporation must pay reasonable compensation to a shareholder-employee for services provided before making non-wage distributions to that shareholder-employee. The IRS may reclassify distributions, personal expenses, purported loans, or other payments as wages when the facts show that the payments were really compensation for services.
In other words, calling a payment a “distribution” does not make it one. The bookkeeping label is not a magical force field.
What Is Reasonable Compensation?
There is no universal salary, fixed percentage, or IRS-approved 60/40 rule. Reasonable compensation is a facts-and-circumstances determination. The appropriate amount for a full-time consultant whose personal expertise generates nearly all the company’s revenue will look very different from the amount for an owner who works a few hours per month in a capital-intensive company operated primarily by employees.
Factors commonly considered include:
The shareholder’s training, experience, and specialized knowledge.
Duties, responsibilities, and time devoted to the business.
The nature and complexity of the work.
The company’s size, financial condition, and compensation practices.
What comparable businesses pay for similar services.
The source of the company’s gross receipts.
The use of capital, equipment, technology, and non-owner employees in producing revenue.
The source of revenue is especially important. If most of the company’s income is produced directly by the shareholder’s labor, a substantial portion of the money paid to that shareholder may properly be compensation. If revenue is generated primarily by employees, equipment, intellectual property, or invested capital, there may be a stronger basis for treating more of the company’s profit as a return on ownership.
Even then, the shareholder’s management and administrative duties must be considered. Owners rarely become passive simply because someone else performs the billable work.
The Risks of Paying Too Little
An unreasonably low salary can expose the company and shareholder to more than an adjustment on the income tax return. If the IRS reclassifies distributions as wages, the consequences may include:
Additional employer and employee payroll taxes.
Failure-to-deposit, late-payment, and late-filing penalties.
Interest and amended payroll tax filings.
Corrected Forms W-2 and income tax returns.
Possible state payroll tax consequences.
Professional fees required to clean up the problem.
Corporate officers who perform more than minor services and receive or are entitled to receive compensation are generally employees for federal employment tax purposes. The shareholder’s ownership interest does not eliminate employee status.
Zero salary is particularly difficult to defend when an active shareholder regularly withdraws money from a profitable company. Paying personal expenses through the business, recording repeated “shareholder loans,” or taking irregular draws does not solve the problem. It may simply make the records harder to explain.
Paying Too Much Can Also Be a Problem
The answer is not necessarily to push every dollar through payroll. Excessive wages can create unnecessary payroll taxes and reduce cash available for distributions or business growth. Salary also reduces the S corporation’s qualified business income, which may affect the shareholder’s potential Section 199A deduction. However, wages can also influence wage-based limitations within that deduction, so the result is not always intuitive.
This is why compensation should not be determined in isolation. The right number may be affected by expected business profit, the shareholder’s other income, retirement goals, health insurance treatment, qualified business income calculations, cash-flow requirements, state tax rules, other owners and employees, and planned bonuses or distributions.
A lower salary does not automatically produce the lowest overall tax liability, and a higher salary is not automatically safer. The objective is a reasonable, supportable amount that works with the shareholder’s broader tax plan.
Compensation Affects Retirement Planning
Shareholder compensation can directly affect retirement-plan contributions. For many employer-sponsored plans, W-2 compensation determines how much the shareholder may contribute or receive as an employer contribution. An owner who keeps wages artificially low may save some payroll tax today while limiting the ability to fund a 401(k), profit-sharing plan, or other retirement arrangement.
That can be an expensive tradeoff, especially for a profitable business owner trying to accelerate retirement savings. Saving payroll tax while forfeiting a substantially larger deductible retirement contribution is not much of a strategy.
Retirement-plan design and compensation planning should therefore be coordinated before payroll is finalized—not discovered after December 31, when many planning options have already narrowed or disappeared.
Health Insurance Reporting Matters Too
Health and accident insurance premiums paid or reimbursed for a greater-than-2% S corporation shareholder are generally subject to special reporting rules. When handled properly, the corporation may deduct the premiums, the amount is reported on the shareholder’s Form W-2, and the shareholder may be eligible for the self-employed health insurance deduction.
The premiums generally must be paid or reimbursed by the S corporation and properly reported for the arrangement to qualify. Simply paying a personal policy and mentioning it during tax preparation may not produce the intended result. This is another reason the compensation discussion should happen during the year, while payroll reporting can still be handled correctly.
Documentation Is Part of the Strategy
A defensible compensation decision should be supported by documentation—not just a number entered into payroll in late December. Useful documentation may include:
A written description of the shareholder’s duties.
An estimate of time spent in each role.
Compensation data for comparable positions.
An explanation of how the business generates revenue.
Records of bonuses, benefits, and other compensation.
Corporate minutes or written resolutions approving compensation.
Periodic reviews reflecting changes in responsibilities or profitability.
A formal reasonable-compensation analysis may be appropriate when the shareholder is highly compensated, the company is unusually profitable, the owner performs several roles, or the planned wage-to-distribution ratio could attract scrutiny. Documentation cannot rescue an unreasonable number, but it can demonstrate that the decision was made thoughtfully using relevant facts.
Why This Should Be a Quarterly Conversation
A salary established in January may no longer make sense in September. The owner may begin working more hours, hire a management team, change responsibilities, add a new revenue stream, or experience a significant increase or decrease in profitability.
Quarterly discussions allow the owner and tax advisor to review year-to-date wages and distributions, projected profitability, changes in duties, retirement goals, health insurance and fringe-benefit reporting, payroll compliance, year-end bonuses, and the tax effect of proposed distributions.
This is proactive tax planning in its most practical form. The goal is not to manufacture the lowest possible salary. It is to establish compensation that is reasonable, tax-efficient, properly reported, and consistent with the owner’s financial goals.
The Bottom Line
S corporation shareholder compensation affects payroll taxes, retirement planning, health insurance deductions, qualified business income calculations, cash flow, and audit exposure. It is not merely a payroll decision, and it should not be based on a generic percentage found online.
If you are an active S corporation shareholder, your compensation should be reviewed at least annually and preferably throughout the year. The discussion should consider your actual duties, the source of the company’s income, comparable compensation data, business profitability, and the rest of your tax strategy.
Tax preparation reports what already happened. Compensation planning gives you the opportunity to shape the outcome while there is still time to do something about it.
Sources
Internal Revenue Service, “S Corporation Compensation and Medical Insurance Issues.”
Internal Revenue Service, “S Corporation Employees, Shareholders, and Corporate Officers.”
