S Corporation Compensation

Top Takeaways

1: S Corporations must pay all employees

S Corporations are small businesses that typically have a limited number of shareholders who many times are employees of the company. And as a general rule, an S Corporation must pay all employees a reasonable salary, including shareholders.

2: Income and Dividends are taxed differently

Income tax rates for 2011 range from 10% to 35%. Dividends, on the other hand, are taxed at 15% in 2011.

3: IRS may recharacterize payments to S Corporation shareholders

S Corps that attempt to characterize wages as dividends for shareholder-employees may have the IRS recharacterize the dividends as wages. This recharacterization by the IRS may subject the S Corporation to penalties and late fees for failure to pay Federal Insurance Contributions Act, Federal Unemployment Tax Act, and state unemployment and disability taxes.

4: S Corporation shareholder salaries must be reasonable

Compensation for shareholder-employees must be reasonable. However, Congress has provided no guidance on what is a reasonable salary. Instead, the various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.
Some factors considered by the courts in determining reasonable compensation:

  • Training and experience
  • Duties and responsibilities
  • Payments to non-shareholder employees
  • What comparable businesses pay for similar services
  • Compensation agreements

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