This is a good question since the topic of S corporation compensation can be easily misunderstood.

The amount you pay yourself in the form of compensation (i.e. wages) is very important. If you are being compensated with an unreasonably low salary to avoid paying employment taxes and instead paying out large distributions to yourself, that is an immediate red flag and could prompt an audit. A lot of S corps get flagged for audits if the corporate officers have little to no wages.

The Internal Revenue Code states that since you are a corporate officer and rending services to the company, you are considered an employee of the corporation so payments in the form of compensation to you are treated as wages.

Therefore, you are subject to employment taxes such as FICA (Federal Insurance Contributions Act) for those wages. Distributions are not subject to these same employment taxes. So the question often arises: How do you determine reasonable compensation?

The Internal Revenue Code does not give specific guidance as to what is considered reasonable compensation as it varies by industry. But, they do list factors as detailed below which the court system has used to determine appropriate compensation.

* Training and experience
* Duties and responsibilities
* Time and effort devoted to the business
* Dividend history
* Payments to non-shareholder employees
* Timing and manner of paying bonuses to key people
* What comparable businesses pay for similar services
* Compensation agreements
* The use of a formula to determine compensation