S Corporation Distributions and Reasonable Compensation
Marco is the sole shareholder and only consultant of an S corporation that provides IT security consulting. In 2024 the corporation collected $400,000 in fees and paid $90,000 of ordinary expenses other than Marco's compensation. Marco took a $60,000 salary and withdrew $250,000 as a distribution; the corporation reported $250,000 of ordinary business income. Marco works 50 hours per week, personally performs all client engagements, and has one part-time administrative employee. Comparable consultants in his market earn $150,000 to $180,000. The corporation has no retirement plan, no written compensation policy, and has paid the same $60,000 salary for four years while distributions have grown. Marco's accountant warns that the IRS may recharacterize part of the distribution as wages. Marco asks about the risk, the factors the IRS uses, and the tax consequences of increasing his salary.
1. Evaluate the risk that the IRS will recharacterize Marco's distributions as wages. What facts cut for and against him?
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An S corporation must pay reasonable compensation to shareholder-employees before making distributions. There is no safe-harbor salary, but the IRS and courts look at the shareholder's training and experience, duties and responsibilities, time devoted, the corporation's dividend history, comparable salaries for similar services, and the salary policy for all employees.
For the IRS: Marco is the sole consultant, works 50 hours per week, personally generates the revenue, and takes $60,000 while comparable consultants earn $150,000–$180,000. Distributions of $250,000 dwarf salary, and there is no written policy.
For Marco: an S corporation owner may receive distributions of profits, and the business has capital and risk. But on these facts, the salary looks artificially low and the IRS would likely prevail in recharacterizing a substantial portion of the distribution as wages.
2. If the IRS increases wages by $100,000, what are the federal tax consequences, including payroll taxes and §199A?
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If wages increase by $100,000 (to $160,000), the S corporation deducts the additional wages, reducing ordinary income and Marco's QBI by $100,000. Payroll taxes: the additional wages are subject to Social Security at 12.4% and Medicare at 2.9%, or 15.3% total, as long as they remain below the 2024 Social Security wage base of $168,600. That is about $15,300, plus FUTA and possible penalties and interest for prior years. The employer's share is deductible.
For §199A, the QBI deduction falls by roughly 20% of the reduction in QBI-about $20,000-if no wage limitation applies. However, higher W-2 wages increase the 50%-of-W-2-wages (or 25% plus 2.5% UBIA) limitation, which matters if Marco's taxable income exceeds the §199A threshold. There is a trade-off between payroll tax cost and audit risk; the salary should reflect market compensation, not tax minimization alone.
3. What should Marco do prospectively?
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Prospectively, Marco should set a salary supported by market data, document his duties and hours, adopt a written compensation policy, and run the salary through payroll with withholding. He should review the salary annually as profits grow. He can correct prior years by amending payroll and paying the employer and employee shares, but the IRS may still assert penalties. A qualified business valuation or compensation study can support the position.