S Corporation Reasonable Compensation: Salary Before Distributions

Build an owner-compensation analysis from duties, time, comparable pay and how the business earns its revenue.

Start with the work the owner performs

An S corporation must pay reasonable compensation for a shareholder-employee's services before treating payments as nonwage distributions. The IRS can reclassify payments as wages. An election or a distribution label does not remove this obligation.

Examine the source of gross receipts. Revenue generated by the owner's services differs from revenue produced by employees, equipment or invested capital. Administrative and management duties also matter. The compensation analysis should describe the business as it operates, including work the owner does behind the scenes.

There is no universal salary percentage

Compensation should reflect training, experience, duties, time, responsibilities and comparable pay, among other relevant factors. A fixed percentage of profit is not a substitute for that analysis. The same net profit can support different salary conclusions in businesses with different staffing and owner involvement.

An illustrative planning file

Consider an owner who divides time between client work and management. The file lists weekly hours by role, compares relevant compensation data, explains the company's revenue sources and records adjustments for actual duties. It then supports a salary conclusion and payroll schedule. The conclusion should be revisited if the owner hires a manager, reduces hours or changes responsibilities.

Suppose a cash forecast shows $240,000 before owner compensation and the supported salary assumption is $120,000. The remaining amount is not automatically available as a tax-free distribution. Employer payroll costs, other expenses, working capital, shareholder basis and the actual return still affect the result. These figures illustrate a process, not a recommended salary.

Coordinate payroll and distributions

Reconcile wages, distributions, reimbursements and shareholder loans during the year. Each has a different purpose and supporting file. Retirement funding and owner benefits should be coordinated with payroll. Correct classifications are easier to maintain when the bookkeeper and payroll provider use the same instructions.

Check shareholder basis separately

Reasonable compensation does not answer whether a distribution is tax-free or whether a loss can be deducted. Stock basis and, for certain loss questions, debt basis require shareholder-level records. Form 7203 addresses these basis limitations. Do not use retained earnings as a substitute for an owner's basis schedule.

Questions for the compensation review

• What duties and hours generated the proposed salary?
• Which comparable pay information was used?
• What changed in staffing, responsibilities or revenue sources?
• Does payroll match the analysis and actual payments?

Continue with the salary planning example, basis guide and accountable-plan records.

Primary sources

• IRS: S corporation compensation and medical insurance
• IRS: S corporations
• IRS: Form 7203