S corporations allow the business to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. But with those great advantages come many rules, including those related to compensation. Shareholder-employees may think there’s no practical difference between income as an owner and income as an employee, but they’d be wrong. The IRS demands that shareholder-employees define both income streams clearly, but it can be vague about how to do this.

According to the IRS, “S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before nonwage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.”

The key reason for the distinction is the different tax rates; nonwage distributions are not subject to employment taxes, while wages are, so the government clearly doesn’t want shareholder-employees to classify all their income as distributions to save on taxes. Indeed, several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense to avoid this supposed “workaround.”

What’s a proper division?

It isn’t always easy to figure out the difference between distributions and wages. According to the IRS, the key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation by looking to the source of the business’ gross receipts.

The three major sources are:

Services of shareholders.
Services of non-shareholder employees.
Capital and equipment.

To the extent gross receipts are generated by services of non-shareholder employees and capital and equipment, says the IRS, payments to the shareholder would properly be treated as nonwage distributions that are not subject to employment taxes. But to the extent gross receipts are generated by the shareholder’s personal services, then payments to the shareholder-employee should be classified as wages that are subject to employment taxes.

Also, shareholder-employees should be subject to wage treatment for administrative work performed by them for the other income-producing employees or assets. The IRS gives an example: Certain managers may not directly produce gross receipts but they assist the other employees or assets who are producing the day-to-day gross receipts.

According to one expert, a good rule of thumb is to think about the salary another business would pay for similar services. Shareholder-employees may be able to look back and see what they were paid for their work before they became owners.

But at the end of the day, the IRS is not explicit about the proper division. However, it is clear on the penalties for getting the division wrong, which are severe. It’s essential to get experienced advice on this topic.