The S corporation owner’s temptation is simple arithmetic. Wages carry employment taxes. Distributions do not. So the wage goes down and the distribution goes up, and the savings look free.
They are not free. Todd Muslow CPA sees this as the single most common self-inflicted exposure among closely held businesses, and it is one of the few areas where the tax authority’s position is well developed and consistently applied.
The Rule, Such as It Is
An S corporation shareholder who performs services must be paid reasonable compensation for those services, and that compensation is subject to employment taxes. Distributions above it flow through without them.
What the law does not do is define reasonable. There is no percentage, no formula, and no safe harbor. Anyone who tells you sixty percent of profit is the rule is repeating something they heard.
The standard is what you would have to pay someone else to do what you do. That is a fact question, and fact questions are decided on evidence.
What Actually Gets Examined
The factors that show up in case law are consistent. Duties and responsibilities. Time devoted to the business. Training and experience. What comparable businesses pay for comparable work. What the company pays other employees.
Also relevant is what the business would look like without the owner. An owner who is the entire revenue-producing function of a company is not credibly worth a token salary, regardless of how the distribution is structured.
Todd Muslow CPA points out the pattern that draws attention fastest: a shareholder taking a small wage and a large distribution in a company with no other employees performing the same function. That combination answers the question before anyone asks it.
The Cost of Being Wrong
When compensation is recharacterized, the distribution becomes wages. That brings employment taxes on both the employer and employee side, penalties for failure to withhold and deposit, and interest running from the original due dates.
The adjustment applies to open years, not just the one under examination, which is how a modest annual savings becomes a material assessment. The math that looked appealing in a single year reverses across three.
There are collateral effects owners forget. Retirement plan contributions tied to compensation shrink when the wage does. So does the earnings record supporting future benefits. You are not only deferring a tax, you are reducing other things that ride on the wage.
Building the File Before Anyone Asks
The defense is documentation created contemporaneously. A description of the owner’s actual duties. Compensation data for similar roles in the same region and industry. Board or member minutes setting the salary with the reasoning attached.
Todd Muslow CPA recommends revisiting the number annually rather than carrying the same wage forward while the company grows. A salary appropriate for a business of one size stops being appropriate as the business changes, and the failure to revisit is itself evidence.
Todd Muslow CPA of Shreveport, Louisiana, is a partner of Muslow+Agnew Group, LLC, working with individuals and closely held businesses on corporate and personal taxation, planning, and consulting.
Two structural points get overlooked. A shareholder performing services must be on payroll, which means an actual paycheck with withholding, not a year-end journal entry reclassifying distributions into wages. The entry does not fix the deposits that were never made.
Health insurance for a more than two percent shareholder has its own reporting requirements tied to the wage, and getting the wage wrong tends to mean getting that wrong too. Todd Muslow CPA points out that these items travel together, which is why an examination of one rarely stays there.
The other misconception worth correcting is that a low wage saves money permanently. It does not. It defers the question until an examiner or a buyer asks it, and both of those parties ask with better information than they had when the return was filed.
The position worth taking is the one you can explain calmly with a file in front of you. If your answer to why the salary is what it is amounts to because that is what we did last year, you do not have a position. You have a habit.