Compensation and the S-corp Shareholder

In working with business owners for many years, I’ve seen just about every variation possible when it comes to owner (shareholder) compensation verses distributions or draws. According to the IRS, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” In other words, the IRS considers no or low salary to a shareholder who is also an officer, and active in the business, an attempt to evade payroll taxes.

The penalty for failing to pay payroll taxes is 100% of the taxes owed, and the IRS is made aware of this when the S corporation files a tax return that reports little or no compensation to its shareholder/officer. The IRS can and will go after the corporation and the shareholder to collect payroll taxes on officer compensation. In determining if the shareholder evaded payroll taxes, the IRS will consider the following:


  1. Did the officer/shareholder provide substantial services? An officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive any remuneration is not considered an employee of the corporation. Therefore, to determine if the officer is an employee, it is important to look at the services the officer performed.
  2. Is the compensation reasonable? Zero pay, or unusually low pay, that is not justified by services performed are examples of unreasonable compensation. Several factors determine reasonableness of compensation: the employee’s qualifications; the nature, extent, and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid; the prevailing general economic conditions; comparison of salaries with distributions to shareholders; the prevailing rates of compensation paid in similar businesses; the taxpayer’s salary policy for all employees; and, in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years. The IRS will ask, “What did the shareholder/employee do for the S corporation?”

As you can imagine, documentation is the key for taxpayers to justify their position if the IRS questions payments to shareholder/employees. Have well-drafted employment agreements; use a consistent approach each year to determine pay and bonuses, etc. By doing so, you can show that compensation plans were adopted in good faith, and the payments are in fact reasonable.

Employees are Exempt or Non-Exempt

A surprising number of payroll service providers, and business owners don’t know or understand the key differences (or implications) of determining whether employees are exempt or non-exempt. Having a good understanding of the rules can save you a lot of hassle down the road.

The typical guideline is that hourly employees are non-exempt, while salaried employees are exempt. This however is not true in several cases, as the correct classification is determined by the actual job duties and salary level, not the job title, job description, or method of payment.

Administrative employees: To qualify as exempt, administrative employees must meet all of the following requirements:

  1. Paid at least $455 per week on a salary or fee basis.
  2. Primary duty must include:
    1. The exercise of discretion and independent judgment regarding matters of significance.
    2. Performing non-manual or office work related to the management or general business operations
    3. Performing work that is directly related to academic instruction or training at a school system or educational institution

Executive employees: To qualify as exempt, administrative employees must meet all of the following requirements:

  1. Executive employees must be paid a salary of at least $455 per 40-hour work week.
  2. They must regularly direct the work of at least two or more full time employees.
  3. Must have the authority to hire and fire other employees, or their recommendations must be given particular weight as to the employment status of other workers.
  4. Primary duties must be management of the business or of a customarily recognized department of the business.

Any employee who owns at least 20% of the business in which he/she is employed is considered exempt.

Computer Employees: This would be defined as a salaried, highly skilled computer professional, and the work must consist of one of the following:

  1. They must apply system analysis techniques and procedures including consulting with users to determine hardware, software, or system functional specifications and design, development, documentation, analysis, creation, testing, or modification of computer systems or programs.
  2. They must also be paid at least $27.63 per hour.

Outside Sales Employees: To qualify as exempt, outside salespeople must meet all of the following requirements:

  1. Primary duty must be selling tangible or intangible items, or
  2. Obtaining orders or contracts for services
  3. They must customarily work away from the employer’s place of business.

Professional Employees: The traditional “learned professions” are generally exempt. These include lawyers, doctors, dentists, teachers, architects, and clergy. Also included are registered nurses (but not LPNs), accountants (but not bookkeepers), engineers who have engineering degrees or the equivalent and perform work of the sort usually performed by licensed professional engineers, actuaries, scientists (but not technicians), pharmacists, and other employees who perform work requiring “advanced knowledge” similar to that historically associated with the traditional learned professions.

Determining an employee’s exemption status is critical. If indeed the employee is nonexempt, they must be paid an overtime premium for hours worked over 40 hours, regardless of the method of compensation (hourly, salary, commission, etc.).