A recent court decision reported that an S corporation shareholder’s salary should be a reasonable compensation. Despite the fact that there is no statute, rule or regulations requiring minimum compensation to be paid, the compensation should be reasonable. To the court, however, the issue was not whether some minimum compensation must be paid, but whether the compensation paid was reasonable. Reasonable compensation analyses apply not only when the issue is whether a salary may be deducted as an ordinary and necessary business expense, but also when the issue is whether payments are wages subject to FICA tax.
One of the continuing advantages of the S corporation format over taxation of partners and LLCs is the ability to treat a portion of payments from an S corporation as return on investment not subject to employment taxes. Many S corporations are fairly aggressive in the amount of S corporation earnings that are treated as shareholder distributions, rather than employee compensation. There are enough S corporations that assert that none of the S corporation distribution is compensation that most of the court cases are devoted to the opposite, and the Internal Revenue Service always wins.
S corporations continue to be a very popular form for doing business as compared to partnerships and LLCs, despite the statutory restrictions on set-up and operation, because of the ability to segregate compensation and dividends.
S corporations need to approach compensation in a reasonable manner. Shareholders compensation is the No 1 audit issue that S corporations encounter. Taxpayers can avoid this issue by establishing and maintaining a reasonable compensation strategy that can be explained to IRS. The compensation should be reasonable in relation to profits and efforts.