When an officer of an S Corporation performs services for the corporation and are entitled to receive payment for those services then their compensation should generally be considered wages. Under the Internal Revenue Code, corporate officers are specifically included in the definition of an employee for federal tax purposes. Because of this, when an S Corporation officer receives these payments for services, they should be treated as wages and not distributions of cash, property, or as loans to shareholder.
The IRS wants to make sure that officers of S Corporations are not avoiding paying employment taxes on officer compensation by treating it as a distribution or loan rather than as wages. Courts have repeating found that S Corporation officers who provide more than minor services to the corporation and receive payments need to be treated as employees whose wages are subject to federal employment taxes. There is a exception to this provided by the Treasury Regulations for officers who do not perform any services or provide only minor services that do not entitle him or her to compensation. These officers should not be considered employees.
The IRS requires that S Corporation officers that should be treated as employees take a “reasonable salary” each year for their services. There is not guidance in Codes or Regulations that say what a “reasonable salary” is and the courts have ruled that it depends on the facts and circumstances of each case.
The following are some of the factors that have been considered by the courts in determining a “reasonable salary”:
-Time devoted to the business
-Wages paid to non-shareholder employees
-Wages paid by comparable businesses for similar services
If you need help determining what a reasonable salary is for your business it is best to consult your tax advisor.