For S Corporation owners, balancing compensation can be a tightrope walk. Unlike other business structures, S Corporations offer a unique tax advantage: distributions to shareholders are not subject to payroll taxes. But here’s the catch—if you’re actively working in your S Corporation, the IRS requires you to pay yourself a reasonable salary before taking those tax-free distributions. Mess this up, and you could be inviting an audit. Let’s dive into the most common red flags for S Corporations regarding compensation.
The IRS’s Biggest Target: Paying Zero Salary
If you’re a shareholder-employee of an S Corporation and pay yourself no salary, you’re putting a giant bullseye on your back. The IRS has made it clear that zero salary is not acceptable for any owner who actively works in their business. Why? Because wages are subject to payroll taxes (Social Security and Medicare), while distributions are not. By avoiding salary, you’re dodging these taxes, which will almost certainly trigger an IRS audit.
Other Common Triggers That Could Lead to an Audit
Beyond paying zero salary, here are other red flags the IRS watches for in S Corporations:
1. Unreasonably Low Salaries
Another major red flag is paying yourself a salary but setting it way below what someone in your role would typically earn. For instance, if you’re running a thriving business but only paying yourself $15,000 a year while taking $200,000 in distributions, the IRS might see this as an attempt to avoid payroll taxes. They’ll likely reclassify part of your distributions as wages, slapping you with back payroll taxes, penalties, and interest.
2. Disproportionate Salary to Distributions Ratio
The IRS often looks at the ratio of your salary to distributions. If you’re taking minimal salary and large distributions, it could signal an attempt to skirt payroll taxes. While there’s no hard-and-fast rule, a significant imbalance will catch the IRS’s attention.
3. Industry-Out-of-Whack Compensation
The IRS compares your salary to industry standards for similar roles. If your salary falls well below what others in your industry typically earn for the same job, it raises a red flag. For example, the IRS will likely question your compensation if you’re a tech consultant but only paying yourself $30,000 a year while the industry average is $100,000.
How the IRS Determines Reasonable Salary
The IRS uses several factors to determine what constitutes a reasonable salary for S Corporation owners, including:
- Your role and responsibilities. Are you the CEO? A manager? Or someone performing administrative tasks?
- Time spent working. The more hours you work, the higher your salary should be.
- Industry standards. Salaries for comparable positions in similar businesses are a key benchmark.
- Company size and profitability. A highly profitable business typically warrants a higher salary for its owner.
The Cost of Non-Compliance
If the IRS decides your salary is unreasonable, they can reclassify your distributions as wages. This means:
- You’ll owe back payroll taxes (Social Security and Medicare) on those reclassified amounts.
- You could face penalties for underpayment of employment taxes.
- The IRS may tack on interest for the time those taxes went unpaid.
How to Stay Compliant
To avoid trouble, follow these best practices:
- Set a reasonable salary. Use industry benchmarks, your role, and your business’s profitability as a guide.
- Document everything. Keep records of your duties, hours worked, and how your salary was determined.
- Consult a tax professional. A CPA or tax advisor can help you structure your compensation correctly while minimizing your tax burden.
Final Thoughts
For S Corporations, paying a reasonable salary is more than just good practice—it’s a requirement. The IRS focuses on shareholder-employee compensation, and paying zero or unreasonably low salaries is the quickest way to get audited. By ensuring your salary aligns with your role and industry norms, you can enjoy the benefits of S Corporation tax savings without the risk of penalties. Play by the rules and keep your business and the IRS happy.
