S Corporations and Reasonable Salary

An S corporation is a type of small business structure that is taxed as a pass-through entity, meaning that the company's profits and losses are passed through to its shareholders and reported on their individual tax returns. As such, S corporations do not pay corporate income tax at the business level.
One of the requirements for an S corporation is that it must pay reasonable salaries to its shareholders who are also employees. The IRS defines a reasonable salary as one that is "commensurate with the services performed." This means that the salary must be comparable to what other businesses in the same industry would pay for similar services.

The IRS considers several factors when determining whether a salary is reasonable, including the employee's education, training, and experience; the duties and responsibilities of the position; and the overall size and financial condition of the business. In addition, the IRS may consider industry-specific data, such as salary surveys and compensation studies, to determine what is reasonable in a particular industry.
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It is important for S corporation shareholders who are also employees to be paid reasonable salaries for a number of reasons. First, paying reasonable salaries can help to establish the shareholder's status as an employee, which is necessary for the S corporation to maintain its tax status. In addition, reasonable salaries can help to reduce the risk of an IRS audit, as the IRS may challenge the S corporation's tax status if it determines that the shareholder-employees are not being paid reasonable salaries.

Finally, paying reasonable salaries can also help to establish the shareholder's status as an employee for purposes of qualifying for certain employment-related benefits, such as unemployment insurance, workers' compensation, and Social Security and Medicare taxes.
In summary, an S corporation must pay reasonable salaries to its shareholder-employees in order to maintain its tax status and to avoid IRS audit risks. The determination of what is a reasonable salary will depend on a number of factors, including the employee's education, experience, and responsibilities, as well as industry-specific data.