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S Corporation Reasonable Compensation

There are categories of business entities responsible for paying shareholder-employee reasonable compensation. An S Corporation[1] is one such corporation. An S Corporation is defined as a type of corporation that elects to be taxed under a section of the U.S. Internal Revenue Code. “S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee” (IRS.gov, “S Corporation Compensation and Medical Insurance Issues,” 8/31/2013). The shareholder cannot receive an amount of S Corporation reasonable compensation that exceeds the amount the shareholder receives either directly or indirectly.

An S corporation that makes a distribution or other type of payment to a corporate officer must treat the distribution “as wages to the extent the amounts are reasonable compensation for the service rendered to the corporation” (“S Corporation Compensation and Medical Insurance Issues”). These provisions are outlined in the instructions to Form 1120S, U.S. Income Tax Return for an S Corporation. It is important to be compliant with these rules to create the appearance of S Corporation reasonable compensation.

The IRS bases provisions with regard to S Corporations on multiple court cases. “Several court cases[2] support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense and subject to employment taxes” (“S Corporation Compensation and Medical Insurance Issues”). For more information about additional S-Corporation reasonable compensation. cases, visit the S Corporations Compensation and Medical Insurance Issues section of the IRS website.

Determining S Corporation reasonable compensation must first be established by evaluating what the shareholder-employee did for the S corporation. To best understand the role of the shareholder-employee, the IRS examines the source of the S corporation’s gross receipts. There are three major sources: 1) services of shareholder, 2) services of non-shareholder employees, and 3) capital and equipment. “If the gross receipts and profits come from items 2 and 3, then that should not be associated with the shareholder-employees personal services and not be allocated as compensation” (“S Corporation Compensation and Medical Insurance Issues”). However, if the total of gross receipts and profits derives from shareholder personal services, then the IRS will reasonably assume that most of the profit distribution is allocated as compensation” (“S Corporation Compensation and Medical Insurance Issues”).

Shareholder-employees are also compensated for administrative work that is generally performed for other income producing employees or assets (“S Corporation Compensation and Medical Insurance Issues”). Additional factors that determine reasonable compensation include: training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, payments to non-shareholder employees, and compensation agreements. There are additional factors that determine reasonable compensation such as the use of a formula as a tool for calculating compensation and payments to non-shareholder employees.

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[1] An S Corporation is defined in terms of U.S. federal income tax designation. It is a corporation that elects to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. An S Corporation does not pay federal income taxes. Instead, the corporation’s losses and/or income are divided among and passed through to its shareholders. The shareholders report the income or loss on their individual tax returns.

[2] References to court cases include the following: authority to reclassify (Joly vs. Commissioner, 211 F.3d 1269 [6th Cir., 2000]); reinforced employment status of shareholders: Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 (2002)

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