The 20 percent deduction on pass-through income, introduced as part of the 2017 Tax Cuts and Jobs Act, could make subchapter S ownership even more appealing to many contractors. But take care—the question of “reasonable compensation” for S corporation officers is consistently an area of concern to the IRS.
To reduce payroll tax liability, S corporation officers might try to pay themselves a nominal salary and instead take most of their earnings in shareholder distributions. But the Internal Revenue Code establishes that any corporation officer is an employee who should be paid reasonable compensation.
The question, of course, is how to define the word “reasonable.” There are no hard-and-fast rules, but the IRS does offer a list of specific factors that tax courts have considered when deciding the issue.
These include the shareholder’s duties, responsibilities, training, and experience, as well as the time and effort devoted to the business. Written compensation agreements and formulas are also considered, along with comparisons with what similar businesses pay.
The more of these factors you can demonstrate in your favor, the better your chances of convincing the IRS or a tax court that your officers’ salaries are reasonable and that you are not using S corporation distributions to illegally avoid paying Social Security, Medicare, and unemployment taxes.
The consequences of failing an audit for reasonable officer compensation can be quite costly, so contractors who use this corporate structure should ensure that the salaries they pay themselves and other active shareholders will stand up to scrutiny.