An S Corp Officer’s Reasonable Compensation “How To” Guide

Wage Optimizer

One of the primary tax benefits of organizing a business as an S Corporations is the ability to pass business profits directly to an employee owner (officer) in the form of profit distributions which are subject only to regular income tax, thereby alleviating self employment tax to a degree. However, the IRS requires that employee owners also be compensated with regular wages in a reasonable way. What’s more, the IRS also has established the authority to reclassify profit distributions as wages when reasonable compensation has not been paid, and to assess additional payroll taxes, penalties, and interest as a result. This post discusses key concepts of reasonable compensation and provides resources to help an S Corp employee owner determine reasonable compensation.

Defining Reasonable Compensation

In the Instructions for Form 1120S the IRS clearly cautions that “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.” The key component of this instruction for our purposes is “services rendered.” In establishing reasonable compensation for employee owners, it is thus required to consider and quantify services rendered, both specialized and general administrative. Additionally, the IRS considers the amount of gross receipts generated by the activities of the officer. What this means is that there are effectively two components that must be weighed when determining reasonable compensation, the first being a fair assessment of the employee owner’s actual services (or tasks) performed and the second being the amount of gross receipts attributable to those services.

Calculating Wages Based on Services Rendered

First, in order to assess reasonable wage compensation for services rendered, we need to establish a number of hours for which to ascribe services to. Though the Fair Labor Standards Act does not define full-time employment, both the IRS and the United States Tax Court have previously adhered to the definition of “year-round, full-time” work as 2,080 hours per year in McAlary v IRS. The simplest way to then proceed is to define each of the tasks performed by the officer in service to the S Corporation, the officer’s relative level of skill for each, and the percentage of the officer’s total effort for each in turn, totalling 100%. Next, using data from the US Census and the Bureau of Labor Statistics’ National Compensation Survey, it is possible to establish a fair-market wage for each task performed (based on task as defined, locality, and level of expertise) and to ascribe that wage to each task in turn. Finally, multiply each task’s percentage of effort by 2,080 total hours, and multiply the product by the wage determined to be appropriate for the task. Adding up each of the wage totals will provide a reasonable estimation of annual compensation for the officer based upon prevailing market rates. A simple example is provided in the table below.

Example: Wages Calculated for Web Development Business Owner

Task Aptitude Percentage Hours Wage Annual
Administrative – Bookkeeping Below Average 2% 41.6 $17.35 $721.76
Administrative – Customer Service/Support Average 15% 312 $23.60 $7,363.20
Human Resources – Hiring & Training Average 3% 62.4 $17.35 $1,082.64
Marketing – Sales Average 20% 416 $20.39 $8,482.24
Procurement – Purchasing Average 5% 104 $17.35 $1,804.40
Web Development Above Average 55% 1,144 $40.50 $46,332.00
Total 100% 2,080 $31.63 $65,785.24

Well-referenced calculations such as these have been used by the IRS internally to determine reasonable compensation and are highly defensible in the event of an audit.

Balancing Wage Compensation with Gross Receipts

The second component of calculating reasonable compensation involves allocating services performed by the officer to gross receipts generated as a result of those efforts. Employee owners who perform all of their own work directly will most likely need to allocate all business profits as wages in order to comply, regardless of calculated annual fair-market wages. However, employee owners who employ additional workers (on either an employee or contract basis) or substantial capital and/or equipment in creating value/profits will be able to defensibly allocate income to distributions of profit. Considerations for allocating income to profit must be made on a case by case basis, and it is in the best interest to always consult with the business’s tax advisor and or attorney when determining reasonable compensation. As a general rule the officer of an S Corp must allocate to wages a percentage of business income that is equal to or greater than receipts that are attributable to services performed by the employee owner. The calculator (link:) provides a handy reference for S Corp employee owners to quickly calculate wages, profit distributions, and profit-sharing plan contributions based on a the percentage of income that must be allcoated to wages.



S Corporation employee owners must be mindful of many factors when determining reasonable compensation. Most importantly, they must ensure that they are adequately compensated for services rendered to the company when viewed in light of fair-market wages for similar services and when viewed in light of the percentage of gross receipts generated as a result of their services. Documenting well-referenced calculations that determine annual salary based on prevailing wages and balancing officer wages with a percentage of receipts allocable to their efforts using WageOptimizer’s calculator (link:) will help S Corporation officers ensure they are compensating themselves reasonably before profit distributions.

Additional Resources

Forbe’s: S Corporation Shareholder-Employee Loses Reasonable Compensation Case, Sun Rises In East

Fox Business: Reasonable Compensation and Your S Corporation

Forbe’s: Tax Geek Tuesday: Reasonable Compensation In The S Corporation Arena

Forbe’s: The Top Ten Tax Cases Of 2012, #4: S Corporation Shareholder Reasonable Compensation – How Much Is Enough?

IRS: Wage Compensation for S Corporation Officers

IRS: S Corporation Employees, Shareholders and Corporate Officers