What is a reasonable salary?

This question is one that any entity may be faced with, but for S corporations, it is becoming a hot topic. In 2009, a U.S. Government Accountability Office report noted that the combined 2003 and 2004 underreported shareholder compensation was $24.6 billion for corporations with fewer than three shareholders being responsible for nearly all of that. How is that relevant to the IRS?

As a shareholder/officer in an S corporation, there is a tax advantage to receiving dividend distributions over compensation payments because of the later being taxed with payroll taxes. Thus, there was a substantial amount of social security and medicare tax dollars not paid on that $24.6 billion in unpaid wages. Those dollars went out in dividend distributions. Historically, there has been no guidance to determine which monies are for services provided versus distributions. So, how would you determine how to separate payments that should be compensation over distributions?

To help with this concern, IRS has recently summarized the factors considered by the courts for determining reasonable salary:

What is the nature of the business?
If profits are generated primarily by personal efforts, a significant portion of the profits should be paid out in compensation.

What does a similar business pay for those services?
It is difficult to argue a lower wage compared to industry norms.

What is the experience level of the individual?
The shareholders wage should be higher than the highest paid nonshareholder if the shareholder has more responsibilities.

What amount of time/effort is devoted to the business?
A shareholder who provides limited services is not required to take compensation.

What are the corporation’s ratios?
If the ratios indicate the corporation is more profitable than similar companies but is paying less salary to the shareholder-employee, there would need to be differentiating factors that would justify this lower wage.