Reasonable Compensation S Corporation Salary

by Tom Andrews, CPA

The S Corporation is a popular tax planning tool utilized by many captains and crewmembers in the yachting industry.  The purpose of this column is not to discuss the reasons for forming or not to form an S Corporation but to discuss the concept of “reasonable compensation”

The two most common ways to withdraw cash from the corporation are to pay yourself a salary as the employee of the corporation or to pay yourself a distribution as the owner of the corporation.  The difference between paying yourself a distribution and paying yourself a salary is that you must pay Social Security and Medicare tax on transfers that are considered salary.  When faced with the prospect of having to pay the extra tax that is called Social Security and Medicare, most clients of mine will tell me that they would rather not pay themselves a salary and simply take cash out as a distribution, this way they won’t have to pay any Social Security and Medicare.  THIS IS A RED FLAG.

The nature of the shareholders’ income is subject to IRS scrutiny, especially if they provide more than minor services to the corporation. Shareholders who receive or are entitled to receive payment are considered employees whose compensation is subject to federal employment taxes (Social Security and Medicare). 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 loans.  If the corporation ends up being audited and the IRS notices that the distributions far exceed the wages the IRS may reclassify the distributions as wages and assess the unpaid Social Security and Medicare.

Now that we have identified a critical concept of operating an S Corporation you must now ask yourself “what is a reasonable compensation?”…..There are numerous factors that are considered when determining “reasonable compensation,” including time and effort devoted to the business, duties and responsibilities, training and experience, and what comparable businesses pay for similar services.  When I sit down with a client to determine reasonable salary I normally ask them how much would it cost for their corporation to hire someone to do their job and perform the services that you are performing for your company.

Once you have determined how much of a salary you are to be paid from your S Corporation I recommend that you transfer a fixed amount from the corporate bank account to the  personal bank account and make sure you coordinate with your accountant to ensure you are sending the proper amount of taxes to the IRS on the proper deadlines.

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