So why take a salary? Because the law and the IRS say you have to.
In a recent court case, the
taxpayers took no salary from their S corporation. Instead, they withdrew funds by means
The corporation had no loan documents or other records showing the
existence or amounts of the alleged loans and the corporation's tax returns did not show
any loans on the balance sheet accompanying the tax return. The taxpayer and his son
entered into agreements with the corporation that their sole compensation for services
would be their share of corporate profits.
The IRS thought otherwise. It argued that the agreements should be
disregarded as devices to avoid paying employment taxes and the amounts paid to or on
behalf of the taxpayer and his son should be treated as employee wages for personal
services rendered the corporation. Under IRC Sec. 3121(d) an employee means:
- any officer of a corporation, or
- any individual who, under usual common law rules
applicable in determining the employer-employee relationship, has
the status of an employee.
The Court looked at the relationship between the taxpayers and the
corporation and found that they were employees. After resolving that question, the Court
had to determine what would be reasonable compensation. The Court looked at many of the
same factors that courts look at when determining reasonable compensation when the IRS
claims a shareholder/employee's compensation is too high. However, because the corporation
here kept no books or records, the Court just accepted the IRS's determination. Had the
corporation kept records the taxpayers could have argued that a lower amount was more
How much salary should you take?
That depends on the
circumstances. If you do significant work for the corporation or are an officer, and
report no salary, you're asking for trouble. In fact, not reporting an amount on the line
'Compensation of officers' is probably a tipoff to the IRS. They figure that every
corporation has a officer that does some work for the corporation. It may be a small
amount, but there should be something on that line.
Ok, you're resigned to reporting something. Now how much? That
depends on the facts and circumstances. You might truly be a passive investor, have other
interests, or spend only a minimal amount of time working for the corporation. If you keep
a log of your hours, and you can put a dollar amount on them, you can compute the amount.
For example, you have other interests so you only spend about 1,000 hours a year working
in the business. The business is small and not very profitable. You could hire someone to
do your job for $25 an hour. A salary in the area of $25,000 would be reasonable. Even a
slightly lower amount would probably not be challenged.
On the other hand, you're the brains and reputation behind a
four-man consulting business with profits of $350,000 a year and you take a $20,000
salary. Expect a problem from the IRS.
Justification for a low salary.
Here are some factors that
might justify a low salary:
- The business is losing money or only modestly profitable.
- The business is in start-up mode and needs to reinvest the cash.
- The business is very capital intensive and you've invested a large
amount of equity capital. You're entitled to a return on the money.
- Your salary is in line with what other employees in the same business
and industry are getting for the same work and skill level.
The rule is that officers of the corporation that
provide more than minor services are employees and must receive a salary. You might be
able to avoid paying a salary to the corporate secretary who just sits in on board
meetings twice a year and signs formal papers when the president or other signer is out of
the office. But justifying the payment of no salary to the president will be difficult in
There are at least two situations where an officer probably need not
be paid a salary. One is where the corporation is inactive. The other is where the
activities of the business don't warrant any work from the officers. For example, you set
up an S corporation solely to hold real property that's rented to another business. The
work associated with the rental activities would be minimal.
If relatives work for your business, many of the
same rules apply. For example, your father is retired but works for the business 20 hours
a week. The business pays him no salary. You, personally, pay some of his living expenses.
The IRS could force you to pay him a salary.
Independent contractors and intercompany
may find yourself in a situation where you work for the S corporation in a capacity as an
independent contractor. For example, you're the president and a 50% shareholder of Madison
Inc., which owns a retail store. You're also a licensed plumber. You do extensive plumbing
work in the store which you bill through your plumbing business. As long as the charge is
based on an arm's length transaction, there should be no problems. Similarly, the
corporation could be one of several related businesses where another corporation performs
management functions for the other businesses. Again, the charge should be based on an
arm's length transaction.
For S corporation shareholder/employees the worst
approach you can take is to pay yourself no salary. That's probably an immediate
Even a salary that the IRS considers unreasonably low is better. Should the IRS
re-characterize some of the distribution as salary, you stand a good chance of avoiding a