Officer Compensation for S-Corps: IRS Compliance Guide

compensation for officers in an S-corp

S-corporations are a popular business structure for small businesses. They provided many benefits to their owners, including pass-through taxation and liability protection. Though S-corp owners have benefited from the low rate of audits in recent years, the IRS is arming itself with a larger budget in the next few years, making officer compensation for S-Corps a bigger deal.

S-corp owners need to ensure that they follow all the applicable regulations for the classification of income from the business to ensure they are compliant in the next few years as the IRS ramps up its compliance efforts.

What are the IRS Regulations for S-Corp Officer Compensation?

Because S-corp officers can take distributions from the corporation without paying payroll taxes, the IRS requires that part of the funds taken from the corporation be salary. In this case, the S-corporation will pay payroll taxes on the wages but not on any other distributions. 

IRS codes state that “any officer of a corporation, including S-corps, is an employee of the corporation for federal employment tax purposes. S-corps should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.”

This means that S-corp officers must be careful in classifying funds taken from the business. Misclassifying distributions can lead to significant penalties and interest.

Are S-Corp Officers Considered Employees?

The IRS considers S-corp officers employees if they perform more than minor services for the business. Therefore, the compensation pay out for services provided to the company is subject to payroll taxes. 

If an officer does not perform any services for the company, then the officer is not an employee. In this case, the officer could take distributions from the company without classifying any of the distributions as salary.

How Does the IRS Define “Reasonable Salary” for Officer Compensation for S-Corps?

The IRS does not have a specific definition of “reasonable salary.” However, the IRS expects corporations to pay their employees a reasonable salary for their services. But the determination of what is a “reasonable salary” is complicated.

Courts have often become involved in cases of determining a reasonable salary. In general, numerous factors are involved in the calculation, including the type of work, the duties of the officer, and the compensation the company pays to employees of other companies for similar work.

A good rule of thumb is that a reasonable salary is what you would have to pay someone to replace the officer. However, as an S-corp owner, your motivation is to minimize your wages to reduce your tax benefit. Therefore, you must determine how aggressively you want to calculate your salary. You should consult a tax professional if you are unsure what salary your need to pay yourself as a corporate officer. 

What Qualifies as Compensation?

An S-corp passes its earnings to the shareholders, who then pay taxes on the profit at their individual tax rates. S-corp shareholders must take distributions according to their ownership percentage.

The IRS requires that you must treat distributions as wages to the extent that the distributions are compensation for services rendered to the corporation. When reviewing the payments to officers, the IRS will review any transfer of funds to the shareholder to determine if they classify correctly as wages, loan repayments, or distributions.  

What Does it Mean for Taxes? 

The determination of a reasonable salary can have significant tax implications. Payroll taxes are currently 6.2% of income for social security and 1.45% for Medicare. Businesses have to match these employee contributions. So for S-corp officers, the payroll taxes on wages mean that wages will tax 15.3% higher than other types of distributions. State and local taxes may also apply to wages, raising the tax rate even higher.

The IRS is concerned that officer compensation for S-Corps because offices set wages artificially low to avoid these additional taxes. 

The IRS can come after S-corp officers who take unreasonably low salaries to avoid taxes. If the IRS determines the wages are inappropriate, they can impose penalties and fines. However, if the IRS cannot determine the appropriate amount of wages, the case may end up in tax court. Then the company may incur significant legal fees to defend its case.

Corporations need to use their best judgment to determine what constitutes a reasonable salary. Unfortunately, the IRS does not provide specific guidance on what constitutes a reasonable salary. You need to evaluate every case individually.

S-corps should consult with tax professionals and follow industry standards when determining a reasonable salary for their officer employees. This will minimize the probability of an audit or determination that an officer’s salary is unreasonable.

Is S-Corp Officer Compensation Compliance an IRS Priority?

The 2022 Inflation Reduction Act provided approximately $80 billion in additional funding for the IRS. This funding had several purposes but included requirements for expanding taxpayer compliance activities. For example, while the IRS says that it will not increase the number of audits for people making less than $400,000, many S-corp owners have incomes that put them over that figure, increasing their chances of being audited.

The IRS has publicly stated that S-corp officer compensation compliance is a top priority in the coming years. Accordingly, companies should proactively review their office compensation plans. This ensures that they align with the definition of a “reasonable salary.” 

s-corp how to qualify

Closing Thoughts on Officer Compensation for S-Corps

Compliance with employment tax requirements is an important consideration for officer compensation for S-Corps. This is true particularly when it comes to determining a reasonable salary for their officers. While the IRS does not provide specific guidelines on what constitutes a reasonable salary, the agency has made it clear that it is a top priority for enforcement efforts. 

With the expanded resources and capabilities provided by the 2022 Inflation Reduction Act, the IRS is likely to increase its efforts to enforce compliance in this area. Therefore, S-corps should ensure that they comply with all applicable employment tax requirements to avoid potential tax liabilities and legal consequences. 

Looking for answers about your S-corp officer compensation? Turn to TaxHack for expert guidance. Our knowledge and experience are at your disposal. Let us steer you in the right direction regarding your S-corp tax concerns.  Click here for a free strategy session with our pros.

 

Book your session now!