What Is a Reasonable Salary for an S Corporation Officer?
S corporations offer unique advantages when it comes to federal income taxes. This article will explore how S corporations differ from regular corporations and provide guidance on determining a reasonable salary for an S corporation officer to avoid potential tax issues.
Key Takeaways
- S corporations pass earnings through to owners, who then pay taxes on this income at personal tax rates.
- Owners must receive a “reasonable” salary in addition to any distributions they may receive.
- The IRS has guidelines for determining a “reasonable” salary based on various factors.
- Wages paid to S corporation officers are subject to the same tax withholding requirements as other employees.
S Corporations and Taxes
An S corporation (S corp) is a special type of corporation that allows income to pass through to shareholders, who report this income on their personal tax returns. The shareholders then pay taxes on their combined income at personal tax rates.
How S Corporation Employee Pay Works
An officer of an S corporation, such as a president or chief operating officer, is considered an employee for tax purposes. Payments for their services are classified as wages, even though the individual may also be an owner or shareholder. These roles are treated separately for tax purposes.
S Corp Officer Wages Must Be Reasonable
The IRS mandates that compensation for services rendered by a corporate officer must be “reasonable” and not merely classified as distributions, personal expense payments, or loans. Officers must be paid a reasonable salary before any other distributions are made.
Note: The IRS has the authority to reclassify payments that were incorrectly categorized as distributions to wages. Such reclassification could result in additional federal income taxes, Social Security/Medicare taxes, and employment taxes, possibly leading to penalties for underpayment.
How to Determine a Reasonable Salary
Determining a “reasonable” salary involves evaluating various factors, similar to how you would determine the salary for any new employee. The IRS suggests considering the following when determining reasonable compensation for corporate officers:
- Training and Experience: Assess the officer’s qualifications and background.
- Duties and Responsibilities: Evaluate the scope and complexity of the officer’s role.
- Time and Effort Devoted to the Business: Consider the amount of time the officer spends working.
- Dividend History: Review the company’s past dividend payments.
- Payments to Non-Shareholder Employees: Compare with what other employees are paid.
- Timing and Manner of Paying Bonuses: Look at how bonuses are structured and distributed.
- Comparable Salaries: Investigate what similar businesses pay for similar services.
- Compensation Agreements: Review any existing agreements regarding compensation.
- Use of a Formula: Employ a formula or method to determine compensation.
Note: To substantiate the reasonableness of officer salaries, you should use data on comparable salaries. Websites like The Ladders and Salary.com, or consulting with a compensation expert, can help ensure your salary figures are justifiable.
Medical Insurance for Corporate Officers
The IRS closely scrutinizes payments to shareholders owning more than 2% of the company’s shares, termed “more-than-2%-shareholders.” Health and accident insurance premiums paid for these employees must be included as taxable wages. Report these payments on the shareholder-employee’s Form W-2, Box 1, but exclude them from Boxes 3 and 5.
Deducting Officer Salaries as a Business Expense
Salaries paid to S corporation officers, including medical and accident insurance premiums, are deductible business expenses, just like other employee-related costs.
Reporting Officer Salaries to the IRS
If your S corporation’s total receipts are $500,000 or more, you must report officer salaries on IRS Form 1125-E, “Compensation of Officers.” This form should detail each officer’s compensation, the percentage of time they devote to the business, and the percentage of stock they own.
By adhering to these guidelines and maintaining thorough records, you can ensure compliance with IRS requirements and avoid potential tax issues related to officer compensation in an S corporation.
