Tax law requires your S corporation to pay you, the owner-employee, reasonable compensation for the work you do. But what about in a year when your corporation has a loss? Does a lack of net profits absolve you from the obligation to pay yourself a salary?
No. It sounds crazy, but your S corporation can have a net loss for the year and do something that causes a salary.
And if the IRS and/or the courts find that your S corporation did not pay you reasonable compensation, you can experience a new surprise salary, payroll taxes, and penalties. This will make your bad year worse.
Basic Law of Reasonable Compensation
You likely know that there are times when the law requires your S corporation to pay you reasonable compensation. But when exactly does the IRS require this from your S corporation?
Here are some common misconceptions:
- Higher profits equal higher salary.
- Lower profits equal lower salary.
- Zero profits equal zero salary.
That’s not how it really works. The IRS looks to see whether you are taking money out of your S corporation. You know this because the IRS explicitly tells you so.
In Fact Sheet 2008-25, the IRS states that your S corporation compensation will never exceed the amount you receive either directly or indirectly. This means that if you don’t have your S corporation pay you any money or give you any property, your S corporation does not have to pay you a salary.
On the flip side, when your S corporation transfers cash or property to you, this triggers the first step in the IRS analysis to decide whether you must pay yourself a salary.