If you own an S Corporation, you have probably heard that you need to pay yourself a “reasonable salary”. What might not be explained is why.

The answer comes down to how you receive money from the business. Salary is payment for the work you perform, while distributions are payments you receive as an owner. The rule exists to distinguish what an owner earns from working in the business from what they receive because they own it.

Why are salary and distributions treated differently?

An S Corporation generally does not pay federal income tax on its profits at a corporate level. Instead, the income passes through to shareholders to report on their individual tax returns. Shareholders report their share of the S Corporation’s income whether or not that income is distributed to them.

An owner can receive money from an S Corporation in two main ways. Salary is payment for the work the owner performs and is subject to income tax withholding and Social Security and Medicare taxes. Distributions are paid to the owner as a shareholder and are generally not subject to Social Security and Medicare taxes. Distributions may be tax-free to the extent of the shareholder’s stock basis. If distributions exceed the shareholder’s basis, the excess is generally taxable as a capital gain.

Because of this difference, a shareholder who performs services for the S Corporation must receive reasonable compensation for those services before taking non-wage distributions.

For example, suppose the sole owner of an S Corporation personally provides all client services and handles its day-to-day operations. Because the income is primarily generated by the owner’s services, a portion should be paid as wages based on the value of the work performed, and any remaining profit would be available as a distribution. 

What makes a salary “reasonable”?

There is no single IRS formula for calculating reasonable compensation. The analysis may consider factors such as:

• The owner’s training and experience
• Their duties and level of responsibility
• The time and effort they devote to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

Another important consideration is where the company’s revenue comes from. The analysis may look different when revenue is generated from non-owner employees, equipment or invested capital. Even then, an owner who manages the employees or assets may still be performing a service that should be reflected as compensation.

Reasonable compensation should reflect what the owner actually does and how the business earns its money.

Finding the right balance

An S Corporation allows an owner to receive both compensation for their work and profits as a shareholder, and each must be treated appropriately. A reasonable salary should reflect the owner’s actual role in the business, how the company earns its revenue and what similar work would cost in the market.

If you have questions about S Corporation taxation, contact Murtha & Flischel. Our team is available to help you better understand how these rules may apply to your business.