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September 04, 2013 Article 4 min read
S corporations may classify shareholder-employee payments as either salary expense or shareholder distributions. The IRS offers no hard-and-fast rules for estimating reasonable compensation, and thorough documentation to support the S corporation’s classification is key.

The IRS is cracking down on S corporations that misclassify payments to shareholder-employees as distributions — rather than salary expense. Some S corporations do this in an effort to minimize payroll taxes, which in many cases will now be more significant because of the additional 0.9 percent Medicare tax. Under the health care act, the tax applies to individual earned income exceeding $200,000 ($250,000 for joint filers or $125,000 for separate filers).

S corporations that misclassify payments could be hit with costly, time-consuming audits, as well as unexpected tax liabilities, penalties and interest charges. So you should review the salaries of your S corporation shareholder-employees to make sure they’re “reasonable.”

Paying the price of tax breaks

For many years, S corporations have been a highly popular entity choice for business. And their number has continued to grow since Congress relaxed the requirements for electing S status in 2004. Much of this growth has been due to avoidance of double taxation and lower individual tax rates.

In many ways, S corporations offer private business owners the best of both worlds. Like C corporations, they provide limited liability and an unlimited corporate life span. In addition, similar to partnerships and proprietorships, S corporations are flow-through entities for federal income tax purposes. This means that income is taxed only once — at the individual shareholder level.

When paying shareholder-employees, S corporations may classify outflows as either salary expense or shareholder distributions.

Classifying payments as salary expense lowers the business’s taxable income, which, in turn, reduces the amount of taxable income that flows through to individual shareholders. However, salary payments are subject to payroll tax.

Classifying payments as distributions, on the other hand, doesn’t reduce the business’s taxable income, but most distributions are typically payroll-tax-free.

S corporations that misclassify payments could be hit with costly, time-consuming audits, as well as unexpected tax liabilities, penalties, and interest charges.

A dollar-for-dollar trade-off doesn’t exist between classifying shareholder-employee payments as salary expense vs. distributions. In other words, it isn’t a wash from the IRS’s perspective, because the government gets shorted out of FICA and Federal Unemployment Tax Act (FUTA) taxes. In fact, a 2005 study by the Treasury Inspector General for Tax Administration estimated that the agency lost almost $6 billion from unpaid employment taxes resulting from improper classification of S corporation shareholder-employee payments.

IRS audits seek to recoup these forgone taxes when S corporations understate reasonable salaries for shareholder-employees. The IRS looks for various red flags, including the absence of S corporation owners’ compensation expense and an inconsistent salary and distribution history.

Supporting reasonable compensation

The IRS offers no hard-and-fast rules for estimating reasonable compensation. Thorough documentation can help support an S corporation’s classification of shareholder-employee payments.

Executive compensation studies (see “Compensation data resources” below), trade associations and executive headhunters may be able to provide data on reasonable salaries, but estimates should be customized for company- and shareholder-specific factors, including:

  • Size and location
    Large, profitable firms can often afford to pay more than smaller firms. Yet smaller firms may need to pay more to attract talent. Geographic location also may affect salaries. For instance, large urban job markets generally are more lucrative.
  • Corporate compensation policy
    Savvy taxpayers formally document the duties and responsibilities of all employees and compare the amounts competitors pay for similar jobs. This is a company-specific factor, as the protocol for paying employees varies.
  • Economic conditions
    Companies pay higher salaries when the economy is thriving and cut back in leaner times. A tight labor market might necessitate salary increases to retain key employees.
  • Employee qualifications
    Education, professional training, reputation, industry know-how and average weekly workload all contribute to an executive’s worth. Corporate loan guarantees also demonstrate an owner’s contribution to a corporation.
  • An S corporation also might estimate reasonable compensation by considering the rate of return an independent investor would expect from the business. By reviewing dividends and capital appreciation, you can quantify reasonable distributions rather than reasonable compensation.

Identifying risk

To assess your S corporation’s risk, compare the amounts reported for distributions and compensation. Would they appear reasonable to an outsider? Beware of using a one-size-fits-all approach to classifying shareholder-employee payments.

For example, some companies apply a 60/40 split to shareholder-employee payments. In this scenario, 60 percent is allocated to salary expense and 40 percent to distributions. Suppose an S corporation retained all excess cash and made no shareholder-employee payments one year. Would an unrelated party work for nothing? Or, if shareholder-employee payments varied significantly from year to year, would an unrelated employee accept the salary fluctuations that a 60/40 split would generate?

Also realize that the IRS may look at “disguised distributions,” such as shareholder loans, corporate payments of personal expenses or in-kind asset distributions, when evaluating shareholder payments.

Passing muster with the IRS

Unfortunately, there’s no way to guarantee that the salaries you set will pass muster with the IRS. But if you do your homework and show that you’ve made a good faith effort to pay reasonable salaries, the agency is more likely to defer to your judgment. 

Compensation data resources

S corporations can estimate reasonable compensation by referring to some executive salary benchmarking studies. These include:

Before relying on any external source, however, management must understand the data — and limitations — underlying the comparables.