This topic is often misunderstood and the penalty could be as high as getting audited. The amount a corporate officer is compensated (i.e. wages) is very important.

Why is Compensation Important?
If a corporate officer is being compensated with an unreasonably low salary to avoid employment taxes and instead being paid out large distributions, an immediate red flag will go up, increasing the risk of a tax audit. A lot of S corps get flagged for audits if the corporate officers have little to no wages.

What Are the Rules?
The Internal Revenue Code states that corporate officers rending services are considered employees so payments in the form of compensation to them are treated as wages. Therefore, corporate officers are subject to employment taxes such as FICA (Federal Insurance Contributions Act) for those wages. Distributions are not subject to these same employment taxes. So the question often arises…How do you determine reasonable compensation?

How to Determine Reasonable Compensation
The Internal Revenue Code does not give specific guidance as to what is considered reasonable compensation as it varies by industry. But, they do list factors as detailed below which the court system has used to determine appropriate compensation.

* Training and experience
* Duties and responsibilities
* Time and effort devoted 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

Please also note that S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders would report the flow-through of income and losses on their personal income tax returns at their personal tax rates.

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