The classification of S-Corp payments to shareholders is a long standing compliance issue with the IRS. They feel that many taxpayers convert what would otherwise be self-employment income (wages) to distributions, in order to avoid self-employment tax (Medicare and Social Security).
This past December the IRS was successful at convincing a US District Court that an S Corp shareholder-employee's $24,000 salary was not "reasonable" and allowed the IRS to reclassify as salary over $67,000, resulting in additional Medicare and Social Security tax....and...as you would guess...penalties and interest were tacked on as well!
According to IRS fact sheet #2008-25 a list of factors has been issued to help determing whether "reasonable" compensation has been paid. They include:
- 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; and
- use of a formula to determine compensation.