The Rule, In Plain English
An S-corporation must pay shareholder-employees a reasonable salary for the services they perform before distributing remaining profits. This isn’t folklore; it comes from how the Internal Revenue Code treats compensation and payroll tax:
- IRC §162(a)(1) allows a deduction for “a reasonable allowance for salaries or other compensation for personal services actually rendered.” If you perform services, the company’s deductible compensation must be reasonable for those services.
- IRC §§3121, 3306, and 3401 define “wages” for FICA, FUTA, and income-tax withholding. Amounts paid as remuneration for services are wages and are subject to payroll taxes. Paying “distributions” in place of wages does not avoid these rules; the IRS and courts recharacterize them as wages when services are performed.
- Courts have repeatedly upheld reclassification of S-corp “distributions” to wages when owner pay was unreasonably low relative to services (e.g., Radtke, Spicer Accounting, Watson). Translation: if you work, you must be paid reasonably for that work and pay employment taxes on it.
Bottom line: if you perform services for your S-corp, you are required to take reasonable employee wages. Distributions are for profit after reasonable wages.
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