S corp. salary limits.

• Author: Hawn, Sherry B.

The question of S corporation salary limits is commonplace, probably because closely held business clients are eager to know the boundaries and often have a vested interest in the answer.

The basic rule is that S officers' salaries must be reasonable in amount and purely for services, according to Regs. Sec. 1.162-7(a). Moreover, under Regs. Sec. 31.3121(d)-1(b), officers are considered employees of a corporation when they provide substantial services to it. Additionally, according to Rev. Rul. 59-221, S income is exempt from self-employment tax.

Determining Reasonableness

S corporations veering from this narrow path are subject to an IRS recharacterization of the payments made from the corporation to an officer, such as dividends, draws and other distributions. This results in corresponding payroll taxes under Secs. 3111, 3301 and 3401 and, potentially, Sec. 6651(a)(1) failure to file penalties, Sec. 6656(b)(1) failure to deposit penalties and negligence penalties under Sec. 6662(c). The burden of proof is on the taxpayer to show that the income is properly characterized and reasonable.

If tax advisers want to be proactive in serving their clients, they should be ready to address the issue of reasonableness from the IRS's viewpoint. The Service determines reasonable salary according to the facts and circumstances. Generally, the nature of an S corporation as a flow through entity will result in less of an arm's-length bargaining position than in a closely held C corporation. The exhibit above presents the factors at which the courts have looked; see Trucks, Inc., DC NE, 5/24/84. The courts generally group their analyses of these variables into three broad categories:

* Employee performance;

* Salary comparisons; and

* Company conditions.

Exhibit: Considerations in determining S officer reasonable compensation * Employee qualifications and training; * Nature, extent and scope of duties; * Responsibilities and hours involved; * Size and complexity of the business; * Results of the employee's efforts; * Prevailing rates for comparable employees in comparable businesses; * Ratio of compensation to growth and net income (before salaries and tax); * Absence of usual fringe benefits (pension or profit-sharing plan, stock options, etc.), which are available to executives of other companies of comparable size; * Employee's responsibility for company's inception and/or success; * Time of year compensation was determined and by whom; * Correlation...