IRS Requirement to Take Compensation as an S Corp Owner

Why S Corp Owners Need To Be On Payroll

If you’re a business owner, it’s common to think you can pay yourself whatever you want, whenever you want. It’s your business after all, right?

The reality is not so simple if your business has elected S Corporation status with the IRS, and you perform services for your business. The IRS actually requires that active S Corporation owners take “reasonable compensation” and report their wages on a Form W-2 at year-end.

Why Does the IRS Care?

As an S Corp owner, you are not required to pay Social Security and Medicare taxes on your distributions.  But you are required to pay these taxes on a W-2 salary. The IRS wants to collect these taxes on your compensation.

Your services to your S Corp are done as an employee, for which you should be paid a wage. You may continue to take owner distributions as a result of profit generated by the company, but only after paying yourself a reasonable wage.

What Is Reasonable Compensation?

This is an important term to know. The IRS expects you to pay yourself a market value salary for your services.  Consider what you would pay someone else to do your job for you. This salary amount can be based on market data, industry norms, and your own experience. This remains a grey area, and AA Tax CPA can help you determine a reasonable salary.

What’s the Worst that Could Happen?

The biggest risk you can take as an S Corp owner-employee is to take no salary at all, especially while collecting tax-free owner distributions. This is a red flag for the IRS and increases your chance for an audit. If faced with an audit, the IRS can reclassify ALL of your distributions (and more) as wages, thus requiring more Social Security and Medicare taxes to be paid, not to mention steep penalties and interest. Therefore it’s best for you to be proactive and decide your own reasonable salary.