The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation state that “distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
The Internal Revenue Service has the authority to determine what a reasonable salary should be. As a result, if a salary is not taken, the IRS can deem a portion or all of the distributions taken as taxable, reclassify the income as salary and impose employment taxes and penalties on those payments.
According to www.irs.gov, some factors considered by the courts in determining 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
We commonly see business owners take excessive distributions throughout the year without taking a reasonable salary. Please call our office at (630) 584-4555 if you need assistance in determining your salary requirements.