The Rule, In Plain English
An S-corporation must pay shareholder-employees a reasonable salary for the services they perform before distributing remaining profits. This isn’t folklore; it comes from how the Internal Revenue Code treats compensation and payroll tax:
- IRC §162(a)(1) allows a deduction for “a reasonable allowance for salaries or other compensation for personal services actually rendered.” If you perform services, the company’s deductible compensation must be reasonable for those services.
- IRC §§3121, 3306, and 3401 define “wages” for FICA, FUTA, and income-tax withholding. Amounts paid as remuneration for services are wages and are subject to payroll taxes. Paying “distributions” in place of wages does not avoid these rules; the IRS and courts recharacterize them as wages when services are performed.
- Courts have repeatedly upheld reclassification of S-corp “distributions” to wages when owner pay was unreasonably low relative to services (e.g., Radtke, Spicer Accounting, Watson). Translation: if you work, you must be paid reasonably for that work and pay employment taxes on it.
Bottom line: if you perform services for your S-corp, you are required to take reasonable employee wages. Distributions are for profit after reasonable wages.
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Pull ahead and accelerate your business growth!
The first step toward financial success is scheduling a consultation with our team. Bring your questions and concerns to our attention. Our engines are revved and ready to drive your business across the finish line as the champion of your industry!
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