What Is Reasonable Compensation for an S Corporation?

Operating a business as an S Corporation can provide some tax advantages for a company and its shareholders, but it also means complying with rules imposed by the Internal Revenue Service (IRS), including the need for employees to be given “reasonable compensation” for their work.

There is a lot to unpack about S Corporations and the IRS rules that apply to them. Understanding some things about Limited Liability Company (LLC) and C Corporation taxes first can help you grasp how the S Corporation election works and why business owners might choose that option. In this article, I’ll cover all that to give you a good foundation for exploring whether the S Corporation election might benefit your company.

What is an S Corporation?

An S Corporation is a business that gets special tax treatment from the IRS. If it meets certain eligibility requirements, a C Corporation or a Limited Liability Company (LLC) can elect to be taxed as an S Corporation. The Corporation or LLC still must be formed under state law and will retain its corporate or LLC status for the purposes of state law. The only thing that changes is the way the company is taxed.

So, when you hear someone talking about an S Corporation, understand that it is not a business entity in its own right; it is simply a C Corporation or an LLC that the IRS has granted a particular tax status. It gets its name from the Subchapter S tax code under which it’s governed.

To qualify for S Corporation status from the IRS, a C Corporation or LLC must meet the following requirements:

• It must be a domestic business. That means the company must have been formed or incorporated within the United States.
• All shareholders must be U.S. citizens or legal residents.
• Shareholders may be individuals, certain trusts, or estates.
• Shareholders may not be partnerships, corporations, or non-resident aliens.
• The company cannot have more than 100 shareholders.
• The company can have only one class of stock. The IRS considers stock to be in one class if all shares have equal rights to distribution and liquidation proceeds. LLCs do not issue stock, so this rule applies only to Corporations.
• It cannot be an ineligible corporation. Ineligible corporations, as defined by the IRS, are “certain financial institutions, insurance companies, and domestic international sales corporations (which are U.S. companies that receive tax incentives for export activities).”

To initiate the S Corporation election, LLCs and Corporations must have the unanimous support of their members or shareholders and file IRS Form 2553 Election by a Small Business Corporation. New LLCs or C Corporations must file their Form 2553 within the first two months and 15 days after their formation for the election to be in effect during their first year of operation. Existing entities must complete and file their S Corp election form within the first two months and 15 days after the beginning of the tax year if they want the election effective for that tax year. They may file their Form 2553 at any time during the current tax year if they wish the election to take effect the following year. After submitting the form, business owners typically hear within 60 days whether the IRS has accepted the election.

Some states honor the federal S Corporation status without requiring any special state-level filing, while others require entities to file a state form for S-Corporation tax treatment.

If a company fails to follow the requirements necessary to be an S Corporation, such as having more than 100 shareholders, the IRS will automatically revoke the corporation’s S Corporation election status, and the company will be taxed as a C Corporation.

How Is Taxation Different for LLCs, C Corporations, and S Corporations?

LLC

By default, an LLC is taxed as a Sole Proprietorship (if a Single-Member LLC) or Partnership (if a Multi-Member LLC). That means all profits, losses, and tax responsibilities are passed through to and reported on the members’ personal tax returns. Additionally, Multi-Member LLCs must file an information return (Form 1065, U.S. Return of Partnership Income) with the IRS.

Because owners of an LLC taxed as a Sole Proprietorship or General Partnership are considered self-employed, they do not receive a paycheck from which taxes are withheld and the LLC does not pay any portion of the individuals’ Social Security and Medicare taxes. Therefore, LLC members are responsible for making quarterly tax payments to cover their income and self-employment taxes (Social Security and Medicare, respectively, 12.4% and 2.9% of their net earnings from the business). This taxation option provides simplicity. However, LLC members may not enjoy paying the full self-employment tax burden, even though some of it can be deducted on their tax returns. Another potential downside is that all profits from the business increase LLC members’ personal taxable income, possibly bumping them into higher tax brackets.

Alternately, an LLC may elect to be taxed as a C Corporation or S Corporation (if it meets the IRS’s eligibility requirements) — more on that below!

C Corporation

A C Corporation is taxed as its own independent tax entity, filing its own income tax returns and paying taxes at the applicable corporate tax rates. The IRS allows some generous business tax deductions for C Corporations, and they are not limited to a maximum number of shareholders or by restrictions on who can be a shareholder. Shareholders who work for their C Corporation are company employees and have taxes withheld from their pay. Regarding Social Security and Medicare taxes, the C Corporation pays half of the amount due, with the other half deducted from the shareholder’s paycheck (as FICA tax). Profit distributions that the shareholders receive are not subject to FICA tax. One downside to a C Corporation tax treatment is that some profits are double-taxed. The Corporation pays taxes on the profits, and then individual shareholders pay taxes on the dividend income they receive from the business. If a C Corporation meets the IRS’s eligibility requirements, it may opt to be taxed as an S Corporation instead (which I’ll explain below).

An LLC may elect to be taxed as a C Corporation, whereby the business owners who work in the business are paid as company employees and participate in company benefit programs, which may result in paying less personal income, Social Security, and Medicare taxes. Depending on where the business is located, the corporate tax rates (federal or state) may be less than individual income tax rates that apply to LLCs taxed as Sole Proprietorships or General Partnerships. To be taxed as a C Corporation, an LLC must file Form 8832 to declare C Corporation tax status and then file Form 1120, U.S. Corporation Income Tax Return. Then, owners file personal tax returns based on their wages.

S Corporation

Like Sole Proprietorships or General Partnerships, S corporations pass corporate income, losses, deductions, and credits through to their shareholders for federal and state tax purposes (and the S Corporation files an information return—Form 1120-S). Some states tax the S Corporation’s income in addition to taxing the shareholders’ pass-through income.

If an LLC chooses S Corporation election, it continues to be taxed on a pass-through basis. However, the business owners who work in the business are considered employees and only pay Social Security and Medicare taxes (FICA) on the wages and salaries they receive from the company. Income paid to them as profit distributions is subject to income tax but not FICA, which may lessen the individual’s personal tax liability.

If a C Corporation meets the IRS’s eligibility requirements and elects S Corporation tax treatment, it is taxed on a pass-through basis. Shareholders report the income (or losses) on their personal tax returns, eliminating double taxation for the company. Choosing to be an S Corporation can also benefit Corporations because it allows the owners to save on payroll taxes, which include self-employment taxes. An S Corporation can divide its business income into salaries and shareholder distributions. That means owners get paid a regular salary for work they’ve done and a distribution of profits generated by the company. The beauty of the tax law for owners of S Corporations is that they only must pay payroll taxes on wages—not the shareholder distributions.

What the Reasonable Compensation Requirement Means for an S Corporation

While an S Corporation election may result in significant savings, it can also invite scrutiny from the IRS.

The ability to split salaries and distributions has caused problems for some LLC owners who elected S Corporation tax treatment and paid themselves a low salary while taking high distributions to reduce their taxable income. The IRS watches S Corporations closely to try to detect people who are trying to game the system.

Unlike S Corporations, where the IRS concerns itself with shareholders’ pay not being high enough, the opposite is true with C Corporations. Because wages are a deductible expense for C Corporations, some owners have taken excessive profits as their salary (which is tax deductible for the business) rather than dividends (which are not tax deductible). That causes the IRS to look out for excessive compensation as a disguise for dividends.

Those who run an S Corporation, such as its officers and directors, set employee salaries. So, if you’re employed by a company you own, you and the other owners can set your own salaries. Many S Corporations are owned by just one person, giving them complete control over their salary.

According to IRS rules, an S Corporation must pay reasonable compensation to each shareholder. And the IRS stipulates that any shareholder who works for the company, even in a minor position, must be considered an employee for tax purposes. It does not, however, declare what percentage of earnings must be regarded as salary rather than shareholder distribution.

This became a problem in the early 2000s when the IRS determined that hundreds of thousands of single-shareholder S Corporations were paying no salaries to owners and collecting distributions instead. You can easily find the story online of David Watson, a CPA who took a $24,000 annual salary from his S Corporation while receiving $220,000 in distributions, on which he didn’t pay employment taxes.

Not liking that one bit, the IRS ruled that Watson’s salary was unreasonably low and charged that $175,000 of the distributions should be treated as taxable wages. Watson fought the matter in court, but the IRS prevailed, and Watson ended up being penalized and forced to pay taxes on most of the distributions he had taken.

On its website, the IRS cites the Watson case and several others as “supporting the authority of the IRS to reclassify other forms of payment to a shareholder-employee as a wage expense that is subject to employment taxes.”

To avoid that, S Corporations must take great care to ensure that compensation paid to shareholders is reasonable.

What is Considered Reasonable Compensation?

According to the IRS, reasonable compensation is “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”

It also suggests that a shareholder’s compensation should be based on how much of the company’s gross receipts are a result of personal services provided by the shareholder. S Corporation owners, officers, and shareholders who provide even minimal services to the company are required to receive wages, with payroll taxes, including the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax, and federal income tax withholding, which must be paid for all employees.

Some factors in determining reasonable compensation, according to the IRS, are:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Distributions history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Where the company is located
• Compensation agreements
• The use of a formula to determine compensation

For their own purposes, an S Corporation can get an idea of what similar companies are paying employees from various sources, including the U.S. Bureau of Labor Statistics, Indeed, Payscale, Zengig, Glassdoor, and ZipRecruiter.

While the IRS has sanctioned no specific formula for reasonable compensation, there are some strategies in place to guide S Corporations in salaries for shareholder-employees:

• A common strategy is the 60/40 approach, which recommends paying 60% of compensation as salary and 40% as distributions. Another approach advocates for a 50/50 split between salary and distributions. These formulas are simple, but they can be problematic and lead to shareholders paying too much in taxes or the IRS claiming a salary is unreasonable. If a shareholder has a business profit of $80,000 for the year and takes a 60/40 split, the salary would be $48,000. If the average salary for the same job is listed at $70,000 by the Bureau of Labor Statistics, it might set off alarm bells with the IRS. Conversely, if the shareholder’s business profit was $200,000 for the year and they took a salary of $120,000, they could be paying taxes on much more than the IRS would require.
• Some S Corporations set salaries as percentages of their net or gross revenues, while others base salaries on the Wage Base Limit set by the IRS for Social Security taxes. In 2024, the yearly wage base limit for Social Security taxes was $168,600 and it is projected to increase to at least $174,900 in 2025. That means taxes are only taken from income up to that amount, leading some S Corporations to adopt that amount as what they pay in shareholder wages.
• Another strategy is to pay shareholders $100,000 of profits in wages and take the rest in distributions. Some S Corporations and their accountants use IRS tax return data to determine the salaries of shareholders in comparable businesses, but that tax return data reflects average salaries from across the country without considering geographic differences in pay.

Generally, these and other formulas provide simple guides for what to pay shareholders, but they are problematic in that most don’t consider the factors the IRS recommends using to determine reasonable compensation. Also, because they are not IRS formulas, they cannot be used to justify salaries if the IRS disputes them.

Consequences for Not Adhering to the Reasonable Compensation Rule

An S Corporation that comes to the attention of the IRS for not providing reasonable compensation to shareholders to reduce payroll taxes or increase profit distributions could face some serious consequences.

Here is a list of consequences that could result:

• The IRS can reclassify money paid to shareholders as distributions to salary subject to employment taxes.
• The S Corporation would likely face fines and fees for underpayment of employment taxes.
• The IRS could charge interest and penalties on back taxes.
• There could be penalties for reporting inaccuracies, negligence, or understatement of tax obligations.
• The company could face legal consequences such as lawsuits charging leadership with making compensation decisions that were not in the company’s and its stakeholders’ best interests.
• The IRS could revoke the company’s status as an S Corporation.

Tips for avoiding issues with the IRS:

• Regardless of how you determine reasonable compensation, you can help safeguard your S Corporation by paying attention to the division of salaries and distributions and keeping careful records in case you need to answer to the IRS.
• Analyze salaries annually to make sure they’re up to date. Standards regarding shareholder pay may change over time, so don’t be lulled into complacency once you’ve established what you consider reasonable compensation.
• Keep careful records of how you determined reasonable compensation, making sure you can cite all the sources and calculations used. Finally, look for data sources that are accurate and unbiased. Government sources such as the Bureau of Labor Statistics or the U.S. Census Bureau are probably more reliable than a source like Zengig, whose reporting methods may be questioned by the IRS.

Common S Corporation FAQs

Are an S Corporation’s shareholders’ distributions taxable?

Profit distributions, also known as dividend distributions, are subject to income tax.

Nondividend distributions, payments made to shareholders as a return of their capital investment in the company, are not paid from the S Corporation’s profits and, therefore, are not subject to income tax. Those distributions reduce the shareholder’s basis in the stock. When an individual’s stock basis reaches $0, they must report their dividend distributions as capital gains.

Can a C Corporation own an S Corporation?

No. A C Corporation may not hold stock in an S Corporation. Only individuals (U.S. citizens or legal residents), certain trusts, and estates may be an S Corporation’s shareholders.

Can a Partnership own an S Corporation?

According to the IRS’s eligibility requirements, a Partnership may not be an S Corporation shareholder.

Can a trust own an S Corporation?

Certain types of trust may own shares in an S Corporation:

• Voting Trust – A trust created for the purpose of exercising voting power over stock that is transferred to it may qualify as an S Corporation’s shareholder. To be eligible, the voting trust must originate from a written agreement that contains specific provisions. Also, the trust’s beneficiaries must be treated as owners of their respective portions of the trust.
• Grantor Trust – If the grantor controlling or directing the trust’s income or assets is a U.S. citizen or legal resident and deemed the owner of the entire trust, a grantor trust may qualify as an eligible S Corporation shareholder.
• Testamentary Trust – If a shareholder passes away and their estate transfers the S Corporation shares to a testamentary trust, the trust is a permissible shareholder for up to two years.
• Electing Small Business Trust – An ESBT with beneficiaries who are individuals, charitable entities, estates, or certain government entities may qualify as an S Corporation’s shareholders.
• Qualified Subchapter S Trust – A QSST, a trust with a single income beneficiary elected as the trust’s deemed owner, may own an S Corporation’s stock transferred to it if it meets the IRS’s rules for grantor trusts.

Can an S Corporation own another S Corporation?

An S Corporation cannot be owned by another S Corporation—except if a parent S Corporation elects to treat one or more of its eligible subsidiaries as qualified Subchapter S subsidiaries (QSub). Under that arrangement, the QSub (the S Corporation owned by the parent S Corporation) is deemed liquidated into the parent, and the parent S Corporation’s shareholders directly own the QSub’s stock.

Can an S Corporation own an LLC?

Yes. An S Corporation may be a member of a Limited Liability Company (Single-Member LLC or Multi-Member LLC). 

Can a Single-Member LLC be an S Corporation?

Yes. An LLC with just one member may elect S Corporation tax treatment if the Limited Liability Company meets all of the IRS’s eligibility criteria. 

Can a Multi-Member LLC be an S Corporation?

Yes. An LLC with multiple members may elect S Corporation tax status if the LLC has 100 or fewer members and meets the IRS’s other S Corporation eligibility requirements.

Do you need to run payroll in an S Corporation?

Generally, an S Corporation must set up payroll to pay its employees. An S corporation’s shareholders involved in the day-to-day business operations are considered employees of the company and must be paid wages or salaries through the company’s payroll. So even if the S Corporation doesn’t have other employees, it must likely run payroll.

Does an S Corporation get a 1099 form?

Typically, clients or businesses that contract with an S Corporation for services are not required to send a Form 1099-NEC. Instead, an S Corporation reports its earnings directly to the IRS.

Do an S Corporation’s shareholders pay self-employment taxes?

Because the owners of an S Corporation are generally considered employees, they do not pay self-employment taxes on their share of the company profits. Instead, FICA tax (Social Security and Medicare taxes) on their wages or salaries are withheld from their paychecks. The employee and the employer split the FICA tax responsibility, with half deducted from the individual’s pay and the other half paid by the business.

When are S Corporation taxes due?

S Corporations must file their annual income tax information return by the 15th day of the third month following the close of their tax. For example, if an S Corporation operates on the calendar year, its IRS Form 1120-S is due by March 15 (unless the 15^th falls on a holiday or weekend; in that case, it’s due on the next business day).

S Corporations may request an extension to file up to six months later by submitting IRS Form 7004.

Play It Safe by Getting Professional Guidance

Gauging what is reasonable compensation and remaining in compliance with other IRS rules can be difficult for a small S Corporation. To ensure you’re following all the rules and handling your S Corporation shareholders’ compensation appropriately, it may benefit you to check with a professional for the peace of mind you’re not putting your company at risk of trouble with the IRS.