An S corporation must issue payroll compensation to all employees, including shareholders providing services to the corporation. These wages incur payroll taxes for Social Security and Medicare. There are no payroll taxes on S corporation profits, which draws scrutiny from the Internal Revenue Service. After all, someone must operate a corporation and therefore is an employee. The IRS expects to receive payroll taxes on some amount of employee compensation.
The incentive for S corporation shareholders to minimize payment of wages is escaping payroll taxes. Lower wages result in higher corporate profit, which isn’t subject to payroll taxes. Consequently, the IRS imposes some restrictions on minimizing wages. As a general rule, a shareholder operating a profitable S corporation must receive “reasonable” wages for services.
The IRS has authority to assess back taxes on S corporations that failed to report reasonable wages. Non-payroll distributions to shareholders are considered disguised wages.
Distributions of profit to shareholders should not substitute reasonable wages. Unfortunately, the tax code does not contain a strict definition of “reasonable” in this context. Nonetheless, guidance about the term "reasonable" is available from transcripts of cases before the tax court and IRS notices. These suggest that reasonable wages are determined by hours worked, duties performed, complexity and size of the business, corporate compensation policy, consistency of a shareholder's salary history, economic conditions and directly comparing the wages and distributions a shareholder receives.
Guideline for Distributions
S corporations should exercise care to assure that wages paid to operating shareholders are not below the market wages for their work as employees. For most S corporations operated by their shareholders, the wages of a shareholder should exceed distributions received.
Shareholder distributions from an S corporation should not exceed accumulated corporate earnings. If this occurs, the distributions are subject to income tax but not payroll taxes. Distributions are therefore normally the amounts previously taxed to a shareholder as profit.
Retirement Plan Impact
Payroll is necessary for an S corporation to fund a retirement plan for an operating shareholder. Contributions to retirement plans depend upon compensation. Because S corporation profit -- whether distributed or not -- isn’t payroll compensation, the IRS ruled that funding qualified retirement plans, such as a Simplified Employee Pension Plan, is legal.