S-corporations must pay reasonable compensation to any shareholder or officer who performs services for the corporation.  Employee-shareholders must be compensated for their work just like any other employee of the s-corporation.  

The determination of what is reasonable compensation is a factual question that must be made on a case-by-case basis.  When determining reasonable compensation we must consider the shareholder-employee’s skills, experience, the nature of the work, and the compensation paid to comparable employees in similar positions.

The internal revenue service provides with guidance on reasonable compensation in Rev. Ruling 59-221.  In this revenue ruling the I.R.S. that “the determination of whether a shareholder-employee is receiving reasonable compensation for his services depends upon all the facts and circumstances of each case.”  Rev. Ruling 59-221 provides us with several factors that may be considered in determining reasonable compensation:  the employee’s training and experience, the duties and responsibilities of the shareholder-employee, the time and effort devoted to the business, the corporation’s dividend paying history, the corporation’s size and complexity, the shareholder-employee’s compensation compared to that of non-shareholder employees.

Reg. §1.1366-2 states that reasonable compensation is based on the facts and circumstances of each case and takes into account the employee-shareholder’s contributions to the corporation, the compensation paid to comparable employees, and any distributions made to the shareholder-employer.

David E. Watson, P.C. v. United States (668 F.2d 1008, 11th Cir., 2012) held that an s-corporation shareholder who performs services for the corporation must be paid reasonable compensation for those services.  The determination of reasonable compensation is a factual question that must be based on all the relevant facts and circumstances.

The I.R.S. has the authority to reclassify distributions as wages (I.R.C. §7436, Rev. Rul. 74-44).  These wages are subject to employment taxes.  I.R.C. §§3121(a) and 3306(b) define wages as all remuneration for employment.  Reg. §§31.3121(a)-1(b) and 31.3306(b)-1(b) tells us the form of payment is immaterial and that the relavent factor is whether the payment was received as compensation for employment.  

Veterinary Surgical Consultants, P.C., 117 TC 141 (2001), aff’d sub nom., and Yeagle Drywall Co., 54 Fed. Appx. 100 (3rd Cir., 2002) states that any remuneration received by the shareholder-employee that are considered wages for services provided to the corporation are subject to federal employment taxes.  Additionally, the s-corporation is liable for its share of the applicable federal employment taxes.

Veterinary Surgical Consultants, P.C., 117 TC 141 (2001), aff’d sub nom., and Joseph M. Grey Public Accountant, P.C., 119 TC 121 (2002) held that an officer of an s-corporation is an employee of that corporation unless he or she performs only minor services.  This being said, shareholders are also entitled to a return on their investments.  Consequently, while the s-corporation must pay wages to shareholder-employees for services rendered, the s-corporation is allowed to distribute its earnings to the shareholders as a return on their investment.

Shareholder-employee wages and the related employer employment taxes are a tax deductible expense.  This means that the paying of the wages is almost a wash, as the wages are deductible at the corporate level, thus reducing the flow through income of the s-corporation.  The same wages are included in the income of the recipients as wages on their personal returns.  So, the shareholder’s income from the s-corporation is reduced by the wages and the shareholder-employee’s income is increased by the same amount.  The payroll taxes keep the paying of shareholder-employee wages from being a complete wash.

Shareholder-employee wages paid by an s-corporation to the shareholder-employee are considered when computing the Qualified Business Income per I.R.C. §199A.  The s-corporation shareholders are allocated their share of the s-corporation’s QBI and the s-corporation deducts W-2 wages, including wages paid to s-corporation shareholders-employees.

The penalties for failing to pay shareholder-employees wages can be up to 100% of the applicable employment taxes plus negligence penalties. 

This post is brief synopsis of the requirement that s-corporations pay their shareholder-employees a reasonable wage.  Please consult your tax professional for specific advice.