Reasonable Compensation for an S Corp Shareholder

A Subchapter S corporation (S corp) is a pass-through entity where the company’s income and losses flow through to shareholders where it is taxed as personal income. However, when a shareholder also works for the company, the IRS usually requires the payment of reasonable compensation that is subject to payroll taxes.

A shareholder who owns more than 2% of an S corp must pay Social Security and Medicare taxes on any compensation and the company will be required to pay the employer’s share of those taxes. Additionally, in some cases, the shareholder may be subject to the federal self-employment tax, in addition to state and federal income taxes.

Since compensation paid shareholder employees is taxed more than passthrough income, most S corp shareholders keep their compensation as low as possible. However, if the IRS finds that a shareholder’s pay has been set too low, it can reclassify distributions as wages.

There is no specific calculation for reasonable compensation, but the IRS does consider factors like training and experience; duties and responsibilities; time devoted to the business; non-shareholder employee compensation; and what comparable companies are paying.

Categorised in: HR and Payroll

This post was written by Sean Allaband