If your business is taxed as an S corporation, the IRS has special rules for how owners are paid.
An S corporation is a pass-through entity that is treated very much like a partnership for federal income tax purposes. As a result, all income is passed through to the shareholders and taxed at their individual tax rates.
However, the nature of the shareholders’ income is subject to IRS scrutiny, especially if the shareholder provides more than minor services to the business. Shareholders who receive, or are entitled to receive, payment for services are considered employees whose compensation is subject to federal employment taxes.
This becomes problematic if shareholders have not received “reasonable compensation” for services rendered to the corporation, but have received significant corporate distributions of cash and property or corporate loans.
What is considered reasonable compensation?
There is no no one-size-fits-all answer that you must meet in order to satisfy this requirement. There are many factors that are considered when determining reasonable compensation. These include:
- Time and effort devoted to the business
- Duties and responsibilities
- Training and experience
- Payments to non-shareholder employees
- What comparable businesses pay for similar services
Reasonable compensation also includes withholding certain taxes from that income, like FICA taxes for Social Security and Medicare, federal income taxes and more.
Due to the high number of components that can affect this determination, you should speak with your tax advisor about your specific situation before making a decision.
The bottom line
Since there’s no black-and-white rule from the IRS that explains how much reasonable compensation should be, it’s best to talk to a tax advisor about how you should put it into practice. You can schedule a free call with a DiMercurio Advisors team member to see if you’re on the right track.