Taxable income as calculated on the U.S. Federal Return for an S corporation flows through to its shareholders and is taxed at the individual level, not subject to self-employment tax. 
Because the income from the S Corporation is taxed when it is reported on the federal tax return and thus, flowed through to the shareholder, cash distributions received from the S Corporation are considered already taxed and thus, not taxed up to the amount of tax basis the shareholder has in the company.
When a shareholder takes distributions from the corporation instead of a salary, they may claim that these distributions are being paid to them in their capacities as shareholders and, therefore, are permissible to take money out of the corporation without paying any payroll taxes (i.e., the employer and employee portions of Federal Insurance Contributions Act (FICA) taxes and the employer Federal Unemployment Tax Act (FUTA) tax). Beginning in 2013, the additional 0.9% Medicare tax imposed by Sec. 3101(b)(2) for high-wage earners (but not on employers) provides an even greater incentive for shareholders to take less salary and more cash as a distribution from the corporation.
The term “employee” includes an officer of a corporation or any individual who has the status of an employee under Sec. 3121(d). Corporate officers are clearly employees, and any payments to them for performance of services are considered wages subject to payroll taxes and federal income tax withholding. Most S corporations have shareholders performing substantial services for the corporation as officers and otherwise.
The instructions to Form 1120S, U.S. Income Tax Return for an S Corporation, state, “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 IRS considers no or low salary to a shareholder who is also an officer an attempt to evade payroll taxes.
The penalty for failing to pay payroll taxes is 100% of the taxes owed (Sec. 6672). Therefore, the IRS is paying attention to federal tax returns for S Corporations that reports little or no compensation to its shareholder/officer. The IRS can and will go after the corporation and the shareholder to collect payroll taxes on officer compensation.
Taxpayers and the IRS often disagree about the correct treatment of payments to shareholder/employees because many S corporations are closely held and therefore are not dealing with shareholder payments at arm’s length (see Watson, 668 F.3d 1008 (8th Cir. 2012)). When reviewing these payments, both the IRS and the courts look at two important factors, discussed below.
- Did the officer/shareholder provide substantial services?
Regs. Sec. 31.3121(d)-1(b) provides that an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive any remuneration is not considered an employee of the corporation. Therefore, to determine if the officer is an employee under Sec. 3121, it is important to look at the services the officer performed.
For example, in the Joly court case, the court concluded that the sole owner of the S corporation that built houses was an employee of the corporation because: (1) He actively participated in management; (2) he took a major role in negotiating contracts, obtaining financing, obtaining customers, and reviewing the progress of the construction at home sites; and (3) he performed management functions (Joly, 211 F.3d 1269 (6th Cir. 2000)).
In Veterinary Surgical Consultants, P.C., 117 T.C. 141 (2001), the sole shareholder reported all of his income from his S corporation, of which he was the sole employee who generated all of its income, as S corporation distributions. But the Tax Court, sided with the IRS that the shareholder was an employee of the corporation and that the distributions were compensation for services that should be subject to payroll taxes.
2. Is the compensation reasonable?
Zero pay, low pay, or too much pay that is not justified by services performed are examples of unreasonable compensation. Several factors determine reasonableness of compensation that include:
- the employee’s qualifications
- the nature, extent, and scope of the employee’s work
- the size and complexities of the business; a comparison of salaries paid
- the prevailing general economic conditions
- comparison of salaries with distributions to shareholders
- the prevailing rates of compensation paid in similar businesses
- the taxpayer’s salary policy for all employees and,
- in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years
(see Mayson Mfg. Co., 178 F.2d 115, 119 (6th Cir. 1949)).
According to the IRS, the key to establishing reasonable compensation is determining what the source of the S Corporation’s gross earnings, and therefore, what the shareholder 
did for the S corporation. If the company’s earnings came from services of nonshareholder employees, or capital and equipment, then they should not be associated with the shareholder’s personal services, and it is reasonable that the shareholder would receive distributions as well as compensation.
On the other hand, if most of the gross receipts and profits are directly associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation. In addition to the shareholder’s direct generation of gross receipts, the shareholder should also be compensated for administrative work performed for the other income-producing employees or assets (i.e. Human Resource activities).
Both the courts and the IRS apply several tests to determine reasonableness of compensation. As in most, if not all cases, the burden of proof is on the taxpayer.
Conclusion
Documentation is the key for taxpayers to justify their position with the S Corporation in the event the IRS questions the payments made to the company’s shareholder(s). Therefore, we would advise to have a well-drafted employment agreement for each shareholder; to be consistent each year in determining pay and bonuses; and determine the source of the company’s gross sales, the experience and competence of the officer/shareholder, and time devoted to the business to establish the reasonableness of compensation paid (Faucette Co., Inc., 17 T.C. 187 (1951)).
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