S corporation owners
A salary you can defend, and a basis figure that exists before the year you need it.
Form 1120-S, owner compensation and shareholder basis prepared by a licensed U.S. CPA. The compensation position is documented when it is set rather than argued about later, and stock and debt basis is carried forward every year rather than reconstructed the first time a loss depends on it.
The salary is a position, not a formula
No percentage appears anywhere in the Code. The number you pay yourself is a factual position, worth only as much as the record made when it was set.
An officer who performs services for an S corporation is an employee for employment tax purposes under section 3121(d)(1), and remuneration for those services is wages under section 3121(a). Rev. Rul. 74-44, 1974-1 C.B. 287 is what the IRS relies on where distributions are paid in place of reasonable compensation. The Eighth Circuit applied the same reasoning in David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), looking to the substance of the payments rather than the labels on them: against a $24,000 salary and an expert valuation of $91,044, the court upheld recharacterizing $67,044 of distributions as wages in each of two years.
What holds up is a record made at the time: what the role involves, what comparable work pays, the hours behind it, how much of the earnings are attributable to the owner’s own services rather than to capital or to other people’s work. So the number gets set with a written basis for it before payroll runs, and gets revisited when the facts change rather than carried forward out of habit.
What we cover
The return, the compensation position behind it, and the basis schedule that decides what you can actually deduct.
Return preparation
Form 1120-S and the shareholder K-1s, the owner’s Form 1040 alongside it, and the state returns and pass-through entity elections that follow from where the work is performed.
Compensation
The reasonable compensation position set before payroll runs, with the comparability and hours evidence written down at the time, and revisited when the role or the earnings change.
Basis tracking
Stock and debt basis carried forward annually and reported on Form 7203, so a loss year does not turn into a reconstruction exercise across returns nobody kept the workpapers for.
Payroll and W-2s
Quarterly filings and the year-end W-2, including the accident and health premiums that have to appear as wages on a more-than-2% shareholder’s W-2 to be deductible at all.
Reimbursements
An accountable plan set up properly under the regulations, so mileage, home office and out-of-pocket costs leave the corporation as reimbursements rather than as taxable wages.
IRS notices
Recharacterization examinations, late election relief, penalty notices on Form 1120-S and 941, and the correspondence that follows a basis question on an earlier year.
When to talk to us
Three moments are worth a call. Before the first payroll run of an S corporation year, because the position is far easier to set than to defend. In a year the business loses money, because what you can deduct is limited to basis and that has to have been tracked. And after a notice arrives, while the years at issue are still open.
If the question is whether an S corporation is the right entity at all, or whether an existing LLC can still elect it, that is the entity formation conversation rather than this one.
Frequently asked questions
Is there a percentage rule for an owner’s salary?
No. The 60/40 and 50/50 splits in circulation appear nowhere in the Code, the regulations or any ruling. Section 3121(d)(1) makes an officer who performs services an employee and section 3121(a) makes that remuneration wages. What an examiner weighs is duties, hours, comparable pay, and how much of the profit came from the owner’s labor rather than from capital.
What if the salary in an earlier year was too low?
That depends on whether the year is still open and whether a notice has arrived. The work is to establish what reasonable compensation would have been on that year’s facts, then either correct it through amended payroll returns and an amended Form 1120-S or hold the position, with the reasoning documented either way.
Do I have to file Form 7203?
The instructions require it from a shareholder who claims a deduction for a share of an aggregate loss, receives a non-dividend distribution, disposes of stock whether or not gain is recognized, or receives a loan repayment. Most owners meet one of those in most years. The current revision of the instructions is still December 2022.The ordering rules that decide how much of a loss the form actually lets through are worked through line by line in Form 7203 and the ordering rules.
What happens to a loss I cannot deduct?
Section 1366(d)(1) caps your losses and deductions at adjusted stock basis plus your adjusted basis in debt the corporation owes you. The excess is not lost: section 1366(d)(2) carries it forward with respect to you while you remain a shareholder. Under section 1367, later net increases restore debt basis before stock basis.
How is my health insurance handled?
Notice 2008-1 treats the plan as established by the corporation where the corporation pays the premiums, or where the shareholder pays, furnishes proof and is then reimbursed. Either way the premiums have to be reported as wages on a more-than-2% shareholder’s W-2 and included in gross income before the section 162(l) deduction is available.
Does a salary reduce my section 199A deduction?
It cuts both ways. Compensation paid to you is excluded from qualified business income under section 199A(c)(4)(A), and the corporation’s wage deduction reduces its qualified business income. But W-2 wages are what the section 199A(b)(2)(B) limitation is measured against once taxable income passes the threshold amount, which is adjusted annually. Above the threshold the two effects pull against each other.
We missed the S election. Is it fixable?
Often. A timely election is due on or before the fifteenth day of the third month of the year it takes effect, under section 1362(b)(1)(B). Rev. Proc. 2013-30 grants relief where the entity requests it within three years and seventy-five days after the date the election was intended to be effective, and meets the procedure’s other conditions.
Can I reimburse myself for mileage and a home office?
Yes, through an accountable plan. Reg. 1.62-2(c)(1) requires an arrangement meeting the three conditions in paragraphs (d), (e) and (f) of the same regulation: a business connection, substantiation, and the return of amounts paid in excess of substantiated expenses. Money taken out without those elements is compensation, whatever the bookkeeping calls it.
The compensation number is the work
A short call about the corporation, how the owner is currently paid and whether basis has ever been tracked, and whether it is a mutual fit.