An increasing number of business owners choose to turn their business ventures into an S Corporation in the United States. The popularity is attributable to different tax relaxations that such types of entities enjoy compared to regular corporate entities. The IRS has also slated out figures which suggest that more and more entities are leaving traditional C corporations to choose S corporations, partnerships, and LLCs. Out of about 30 million business ventures in the US, about 7.4 million are S Corporations and partnerships.

If you are also considering forming an S corporation, you need to know some critical elements applicable to such types of business entities. Join us to dig deeper into the relevant details about running an S corporation.

What is an S Corporation?

Also called Small Business Corporations or Subchapter corporations, S Corporations are closely held entities that have a special tax status from the IRS. These entities can pass through to their shareholders their corporate incomes, deductions, and credits due to this special status. All and all, as a result of this separate provision, S Corporations generally do not have to pay taxes on their incomes. Simultaneously, the individual shareholders of an S Corporation divide the total income or loss generated amongst each other.

These shareholders are personally liable for taxes on the share in the overall income. Registering as an S corporation mainly helps in avoiding double taxation. One of the elemental considerations while running an S Corporation is estimating reasonable compensation for the shareholders and officers.

What does reasonable compensation entail for an S Corporation?

All S Corporations have to pay reasonable compensation to their shareholder-employees. These payments are payable in return for the service of the employees. As per form 1120S, the payments, such as distributions, made to a corporate officer shall be treated as wages. It is possible to the extent of the amount of reasonable compensation for the services availed of by the corporation. The payment of reasonable salary should be made prior to all non-wage distributions.

What is the relevance of calculating and paying reasonable compensation?

One of the integral parts of operating an S Corporation is the payment of reasonable compensation. If the Internal Revenue catches an S Corporation for paying lesser compensation than the fair amount, it will penalize the entity. Such a defaulting entity shall have to pay both self-employment tax and income tax on the lower compensation paid. Hence, not calculating a reasonable compensation amount will lead to income tax charges coupled with payroll penalties.

In many cases, the Internal Revenue will also expand your S Corporation’s audit duration to three years. Then, you can become liable to pay taxes and penalties for all three years.

What are the points to remember while determining a reasonable officer’s salary in an S Corporation?

While determining the amount of reasonable compensation for an officer of an S Corporation, you must consider the below-enlisted factors. These factors will help you judge an officer’s eligibility to receive a given figure as compensation.

  • Duties and responsibility of the shareholder-employee
  • Qualifications, training, and experience
  • Dividend history
  • Time and efforts devoted to the operations of the S Corporation
  • Amount paid to non-shareholder employees
  • Manner and time of payment of bonuses to key personnel of the corporation
  • Terms of agreement for compensation
  • The amount which counterpart S Corporation pay for comparable services
  • The type of formula used for determination of the compensation


Withholding necessary tax sums from the payments made to officers

It is also critical for S Corporation entities to withhold federal taxes and FICA taxes, wherever applicable, from the payments made to corporate officers.

Treatment of medical insurance premiums paid on behalf of corporate officers

Many times an S Corporation pays the health and accident insurance premiums for its employees. IRS closely monitors the payments of shareholder officers who more than 2 percent stake in the S Corporation. As per the Internal Revenue Code provisions, the insurance payments of “the more than 2 percent shareholders” should get included as taxable payments. Mention the details of these insurance payments in Box 1 of the personal form W-2 of such shareholder-employee.

In return 1040, if the Form W-2 has the inclusion of medical insurance payments, there is a provision for adjustment of the income from self-employment health insurance. However, if no insurance payment details are disclosed in Box 1, one cannot claim it as self-employment health insurance.

What is the provision for the deductibility of officer salaries as an expense for tax purposes?

Not all payments made to the corporate officials of an S corporation are deductible as business expenses. However, expenses such as accident and medical insurance premiums are considered tax-deductible. All the officers’ compensations must be reported in the tax return with Form 1125-E of the S Corporation with the total receipts more than equal to $500,000. It enlists all the payments made to every corporate officer and the percentage of stake in the entity along with time devoted to service.

What are some of the well-known court rulings related to the calculation of compensation for an S Corporation?

Here are some of the famous court rulings related to compensation made by S Corporations.

  1. Watson vs. Commissioner, 2012, 668 F.3d 1008

Here, Mr. Watson worked as an accountant in his own S Corporation. The entity’s revenue exceeded $ 3 million. He held the degree of a CPA and drew a salary of $24,000. The court passed a ruling that any reasonable person shall consider the amount of payment as a dividend for the services performed. The firm was charged taxes and penalties as the dividends were reclassified as wages.

  1. Spicer Accounting vs. United States, 1990 918 F.2d 90

In a firm where Mr. Spicer and his wife owned a 50-50 percent stake, Mr. Spicer was the only accountant. He was the recipient of only dividend payments from the entity. He claimed that his service as an accountant was charitable. The court ruled that the form of compensation was immaterial. The fact that payments were received as an employee was relevant.

  1. Sean Mcalary Ltd. vs. Commissioner, 2013

Here, the IRS appointed a valuation expert to assess the payment made to a real estate agent. A sum of $100,765 from the S corporation’s total earnings was to be treated as a salary. The person got distributions of over $130,000 and did not pay self-employment taxes on the portion of income in question. The court ruled that the real estate agents act as facilitators. The agent’s overall revenue was not responsible for directly attributable to his role as a real estate agent.

  1. Davis vs. United States, 1994

In an S corporation run by a couple, the wife provided clerical services of 12 hours a month. She charged $8 per hour. The court ruled that since the wife could prove her minimum working hours, she was eligible for the payment.

How can tax outsourcing services from entities like Initor Global help your firm flourish?

The world of taxation remains quite perplexing for most people, including professionals. Many accounting firms and CPAs can find it challenging to handle their clients’ tax demands, including the S corporation entities. Initor Global can lend out impeccable assistance to your firm with different tax demands. We possess the expertise and technological resources to handle various tax preparation and compliance requirements of businesses. Contact us for impressive tax outsourcing services.

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