S corp: reasonable salary for a shareholder-employee

Often advertised, one of the main reasons to elect S corp status for tax purposes as opposed to  partnership is that distributions from an S corp are not subject to self-employment taxes.

We hear very often shareholder-employee saying that they cannot pay themselves because the business is not profitable enough; but when some business money becomes available (from a loan for example), they do not hesitate to take some money out.

However, the IRS is looking after contributions to Social Security, unemployment and Medicare and might re-characterize some of those distributions to wages if the shareholder-employee is not paid enough for his services. “Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances”.

The IRS and the courts will evaluate reasonable compensation based on the following criteria:

  • Experience, training and qualification of the shareholder-employee
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Distribution history
  • Replacement costs (what comparable businesses pay for similar services)
  • Amounts paid to non shareholder employees
  • Compensation agreement in place (if any)
  • Timing and manner of bonus paid to key people


An S corp can lose money and still be required to pay reasonable compensation. The IRS will compare distributions made to and wages received by the shareholder-employee.

Re-characterization to wages will require the immediate payment of payroll taxes calculated on the imposed wages plus penalties & interests.

However, the IRS cannot force a shareholder to take money out of the S corp. If there is no distribution at all, it remains the right of the shareholder to decide a salary for himself or not. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.

If the shareholder loans the S corp some money and from time to time take money out, the IRS can also re-characterize the loan to paid in capital, especially if there is no written loan agreement that includes reasonable interest and schedule of reimbursement.

Tax preparers could also be charged with interests and penalties, malpractice claims and forced to amend returns at no charge if they have not informed their S corp clients.

I created this blog to help understand certain basic aspects of U.S. tax law. Of course, each situation is unique and nothing that is on this site will ever replace the expert advice of a tax professional.

Please do not hesitate to contact me should you have any question