S Corporation Salary Versus Distributions
Diego is the sole shareholder and full-time principal consultant of DMS Consulting Inc., a calendar-year S corporation in Miami. In 2024 the corporation had net income before any officer compensation of $420,000. Diego took $80,000 as W-2 wages and $240,000 as distributions; the corporation retained $100,000. Diego works about 50 hours per week, personally manages client relationships, and has 20 years of experience. A compensation study shows that a comparable principal consultant in Miami would earn $180,000. Diego's stock basis on January 1, 2024, was $30,000, and he had previously loaned the corporation $50,000 on a written note at market interest. The corporation paid $20,000 of health insurance premiums for Diego but did not include the premiums on his W-2. Diego wants to keep the $80,000 salary to reduce payroll taxes and asks whether the IRS can recharacterize the distributions.
1. Evaluate the reasonable compensation risk and the likely IRS adjustment if it recharacterizes $100,000 of distributions as wages. Include payroll tax and W-2 consequences.
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An S corporation shareholder-employee must take reasonable compensation for services before taking distributions. The IRS looks at the shareholder's duties, time devoted, experience, comparable salaries, dividend history, and whether distributions are proportional to ownership. Diego works 50 hours per week, manages clients, and has 20 years of experience. A comparable salary is $180,000, while he takes only $80,000. That gap creates a significant recharacterization risk. The corporation cannot justify the $100,000 difference as a return on capital when it is really compensation for services.
If the IRS recharacterizes $100,000 of distributions as wages, Diego's W-2 wages increase to $180,000 and the corporation deducts the additional $100,000. The corporation owes the employer share of FICA at 7.65% ($7,650), must withhold the employee share ($7,650), and may owe FUTA on the first $7,000 of wages. The corporation may also face failure-to-deposit penalties, failure-to-file penalties for missing or incorrect Forms 941, and accuracy-related penalties. Diego's income tax withholding and W-2 reporting must be corrected. Separately, the $20,000 of health insurance premiums for a 2% shareholder must be included in his W-2 wages for income tax purposes, so the failure to report that amount is another correction item.
2. Determine the tax treatment of the $240,000 distribution before and after any recharacterization, using his stock and debt basis.
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Before recharacterization, the corporation's ordinary income is $340,000 ($420,000 net income less $80,000 wages). Diego's stock basis starts at $30,000, increases by $340,000 to $370,000, and decreases by the $240,000 distribution to $130,000. The distribution is tax-free because it does not exceed stock basis, and Diego has no capital gain. His $50,000 loan is separate debt basis. It can support losses if the debt is bona fide, but it does not increase stock basis and cannot absorb distributions. Repayment of the loan is not income.
After the IRS recharacterizes $100,000, wages are $180,000 and ordinary income is $240,000. Stock basis becomes $270,000 ($30,000 plus $240,000), and the distribution is reduced to $140,000. Ending stock basis is $130,000. The shift does not create capital gain on these facts, but it increases payroll taxes and changes the character of the $100,000 from distribution to wages. The corporation's deduction increases, which reduces the ordinary income passed through on Schedule K-1. Diego should also consider the effect on the qualified business income deduction, because wages are not qualified business income but do affect the wage limitation.
3. What corrective actions and documentation should Diego and the corporation take before filing the 2024 return?
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Diego should set a reasonable salary prospectively and document the analysis. The file should include the compensation study, board minutes or written consent, a description of his duties and hours, client responsibilities, and comparable market data. The corporation should issue a corrected W-2 and file amended payroll returns if wages were underreported, pay the employer and employee payroll taxes, and correct the health insurance reporting. If the 2024 W-2 has not yet been issued, the corporation can correct before filing. If it has, Form W-2c and Form 941-X may be needed.
The corporation should also make sure the 2024 Form 1120-S and Schedule K-1 are consistent with the payroll records. The $20,000 health insurance premiums should be reported as W-2 wages for Diego as a 2% shareholder for income tax purposes, with the appropriate payroll tax treatment. Diego should not treat the entire $240,000 as a distribution if part is really compensation. A reasonable approach is to increase salary to the supported range, reduce distributions accordingly, and preserve documentation for the IRS. The corporation should also confirm that the $50,000 loan has a written note, interest, and repayment terms so it is respected as debt.