Do S-Corp Owners Have to Take a Salary?

Part of WageProof's complete guide to S-corp reasonable compensation.

Usually, yes. An S-corp owner who works in the business and takes money out of it has to be paid a reasonable salary through payroll. Only two kinds of owners can go without one: an owner who doesn't work in the business, and an owner who takes nothing out of it. This article explains the rule, how it applies in the situations owners ask about most, and what happens when a salary that should have been paid wasn't.

When does an S-corp owner have to take a salary?

An owner who works in an S corporation can take money out in two ways: as a salary, paid through payroll like any employee's wages, or as distributions of the company's profit. The salary carries Social Security and Medicare taxes, 15.3% in total on most salaries, and distributions don't. Because a lower salary means less payroll tax, the IRS requires an owner who works in the business to be paid a reasonable salary before taking distributions. A reasonable salary is roughly what the business would have to pay someone else to do the same work.

The rule comes from the payroll tax law. The tax code counts any officer of a corporation, such as its president, as an employee for payroll tax purposes, and IRS Fact Sheet FS-2008-25 confirms that this includes S corporations. The IRS's S corporation compensation page says the salary has to be paid before the owner takes distributions.

So whether an owner has to take a salary comes down to two questions: does the owner work in the business, and does money go from the company to the owner? If both answers are yes, the owner needs a salary.

Common situations

Here is how that rule applies to the situations owners ask about most, starting with the most common one.

The owner works in the business and takes distributions

This is the usual situation, and the answer is yes. If the owner does more than minor work for the company and takes money out, part of that money has to be paid as salary through payroll, with payroll tax withheld and paid. If it is all paid as distributions, the IRS can treat it as wages anyway. In Revenue Ruling 74-44, published in 1974, the IRS treated "dividends" paid to two working shareholders as wages, because they were paid in place of reasonable compensation, and the courts have agreed, as the cases below show.

There is no minimum dollar amount and no IRS percentage. FS-2008-25 says there are "no specific guidelines for reasonable compensation in the Code or the Regulations," and the common 60/40 split is a rule of thumb, not an IRS rule, as our article on the 60/40 rule explains. The salary is based on the owner's work: the duties, the hours, and what the market pays for that work. The fact sheet also says the salary "will never exceed the amount received by the shareholder either directly or indirectly," so it never has to be more than the owner took out.

A low salary can also be challenged. In Watson, described below, the company argued that nothing requires a minimum salary, and the Eighth Circuit still upheld a finding that the owner's work was worth $91,044 a year, not the $24,000 he was paid.

Calling the money something else doesn't change the answer. Owners often call what they take out "draws," and some take it as loans or have the company pay their personal bills. The fact sheet tells S corporations not to treat officers' pay as "cash distributions, payments of personal expenses, and/or loans rather than as wages." In Gale W. Greenlee, Inc. v. United States, 661 F. Supp. 642 (D. Colo. 1985), the company lent its owner money whenever he chose, on unsecured, interest-free demand notes, and the court held the loans were wages. Money the owner lends to the company is different. In Scott Singer Installations, Inc. v. Commissioner, T.C. Memo. 2016-161, the company repaid money its owner had lent it, carried on its books as a loan, and the repayments were not wages. Courts look hard at loans between a company and its owner, so the company's own records have to show a loan.

The company had a loss or little profit

The answer is the same in a year with little or no profit, because the test is whether money goes to the owner, not whether the company made money. In Glass Blocks Unlimited v. Commissioner, T.C. Memo. 2013-180, the company reported net business income of $877 for 2007 and $8,950 for 2008. Its owner, the only full-time worker, took out $30,844 and $31,644 in those years with no salary, and the Tax Court held the payments were wages.

It's the company's first year

There is no exception for a company's first year, either. An owner who builds the business without taking anything out has no salary to set yet. An owner who lives on money drawn from the company needs one.

The owner doesn't work in the business

This is one of the two cases where no salary is needed. A shareholder who only invests doesn't need a salary, because their distributions are a return on the investment, not pay for work. In a company with several owners, only the ones who work in it need salaries. The regulations also leave out an officer who does no work or only minor work and who neither receives nor is entitled to any pay (Treasury Regulation §31.3121(d)-1(b)). An owner who helps out now and then should keep a record of what they do, because that case depends on the facts.

The owner takes no money out

This is the other case where no salary is needed. With nothing going from the company to the owner, there is nothing to treat as wages, so a year with no salary and no distributions doesn't break the rule. Money received indirectly counts, though, including personal bills the company pays and money the owner takes as a loan. The owner also still owes income tax on their share of the profit, which the IRS's instructions for Schedule K-1, the form that reports each owner's share, say is taxable "whether or not distributed." S-Corp Distributions: How They Are Taxed explains this.

What happens if an owner who should take a salary doesn't

When an owner works and takes money out with no salary, or one too low for the work, the IRS can reclassify the payments as wages, up to a reasonable salary. The company then owes:

• back payroll tax on that amount, at rates that depend on whether the owner was already on payroll (IRS examiner manual);
• penalties for not filing payroll tax returns or not depositing the tax, where they apply;
• interest, usually from the date the tax was first due.

The cases show how that plays out:

• In Joseph Radtke, S.C. v. United States, 895 F.2d 1196 (7th Cir. 1990), an attorney who was his company's only full-time employee took no salary and $18,225 in dividends for 1982. All of it was held to be wages.
• In Spicer Accounting, Inc. v. United States, 918 F.2d 90 (9th Cir. 1990), an accountant who worked about 36 hours a week took only dividends and said he did so to avoid payroll tax. The court held his intention had "no bearing," and the dividends were wages.
• In David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), a CPA's company paid him $24,000 a year and passed most of what his accounting firm paid it, $203,651 for 2002 and $175,470 for 2003, to him as dividends. The judgment came to $23,431.23 in tax, penalties and interest.

When the IRS Challenges Your S-Corp Salary covers the audit itself and how the bill is figured.

What to keep on file

Each of those cases turned on its facts, so the protection is a file that records them at the time the salary is set.

For an owner who works in the business and takes money out, the file holds a dated analysis of the owner's duties and hours, the wage data each duty was priced against (such as Bureau of Labor Statistics wage data), and a board minute approving the salary. In Watson, no documents showed how the $24,000 was set. If the owner works part time, a calendar, timesheets or billing records show the hours. In Glass Blocks, the court gave the owner's unsupported claim of 20 hours a week "little weight."

When the salary is zero, the file shows why. For an owner who took nothing out, that's the bank statements and the ledger, showing no distributions, no loans to the owner and no personal bills paid. For an owner who doesn't work in the business, it's a short description of who does the work and what the owner's role is. For money paid back on a real loan, it's a signed note, the loan on the books every year, and repayments that follow its terms.

Year-End S-Corp Reasonable Compensation for CPAs covers when a CPA should put that record together.

Setting and documenting the salary

For most owners, the answer to this article's question is yes, and the protection is a dated record of the duties, the hours and the market wage data behind the salary, made before the year's last payroll. Owners who want that done can use WageProof. We match the owner's tasks to BLS wage data for the county's wage area (or a broader or older figure where the local one is not published) and the owner's experience level, and the result is a dated PDF report for the corporate records and the CPA's file, like this sample report. CPA firms can run reports for their clients on an annual firm plan, and owners can start a report when they're ready.

This article is general information, not legal or tax advice. Whether a salary is required, and how much, depends on the full facts of the business; consult a qualified tax professional before setting compensation.