Tip: “Reasonable” Wage Compensation for S Company Officers

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Issue:  Employers set up an “S” corporation, and pay themselves a minimum officer’s salary  in an attempt to avoid employment taxes and instead receive payments in the form of cash dividends.  Alternatively, the owner-employers might boost their salary in order to take a greater deduction.

The U.S. Supreme Court has declined to review a decision (Watson, P.C. v. U.S.) of the Court of Appeals for the Eighth Circuit, in which an S corporation was held to be paying an unreasonably low salary and was thus liable for employment taxes on dividends reclassified as salary.

In some cases, an S company may elevate a salary in order to take a greater deduction.  So, it is important to know just what is a reasonable salary.

There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

The IRS Fact Sheet 2008-25, August 2008 lists some of the factors the courts shall use to determine “reasonable 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

The Eighth Circuit used these criteria to decide the case.  Therefore, it is a question of fact in each case whether compensation is “reasonable,” given the general law that S corporations 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.



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