If a shareholder‑officer substantively works in the business, pay them a bona fide wage commensurate with what the market would pay for those services. See IRS Fact Sheet “Wage Compensation for S Corporation Officers (FS‑2008‑25)” (https://www.irs.gov/pub/irs-news/fs-08-25.pdf).

Why “reasonable compensation” matters

• Officers are employees; their compensation for services is wages subject to withholding and FICA/FUTA. Paying little or no wages while taking distributions invites recharacterization and assessment of employment taxes. Reasonable compensation applies whenever services are performed and payment is received or owed, even if the officer is also a shareholder. See “Who Are Employees?” in Publication 15‑A (2025) (https://www.irs.gov/pub/irs-pdf/p15a.pdf).

• The IRS explicitly warns S corporations not to avoid employment taxes by treating officer compensation as distributions, personal expense payments, or loans. If a shareholder‑officer provides more than minor services and receives remuneration, treat those amounts as wages subject to employment taxes. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf).

The governing standard and factors the IRS uses

• There is no single statutory formula. Reasonableness is assessed case‑by‑case. Common factors include: training and experience; duties and responsibilities; time and effort devoted; dividend/distribution history; payments to non‑owner employees; timing and manner of bonuses; comparable businesses’ pay for similar services; compensation agreements; and any formulas used to compute pay. These are applied holistically to determine whether compensation is commensurate with the services rendered. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf).

• Officers who perform no services or only minor services and who neither receive nor are entitled to receive any remuneration are not employees; otherwise, they are employees and wages must be paid for services performed. See Publication 15‑A (2025), “Who Are Employees?” (https://www.irs.gov/pub/irs-pdf/p15a.pdf).

A practical, step‑by‑step methodology to determine reasonable salary

• Define the role and quantify duties and time
  Document the officer’s title, core functions (e.g., CEO, CFO, production manager), and the percentage of time devoted to the business (full‑time, part‑time, seasonal). Reasonableness hinges on duties and time/effort devoted to the business. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf).

• Benchmark with market compensation
  Gather compensation data for comparable roles in similar industries and geographies (e.g., pay surveys, staffing offers, public salary data). Adjust for the officer’s training and experience and the company’s size and complexity. Comparable pay is a major factor in determining reasonable compensation. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf).

• Calibrate for company‑specific context
  Consider the business’s profits, risk profile, capital needs, and distribution history. If the business pays significant distributions while wages are minimal, the IRS may view wages as unreasonably low relative to services performed. Conversely, if profits are modest and the officer truly works part‑time, a lower wage may still be reasonable. Dividend/distribution history and payments to other employees are relevant to reasonableness. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf).

• Document the compensation decision
  Prepare a written compensation policy or board minutes noting the factors, data sources, and rationale for the salary, and any bonus structure. Written compensation agreements and formulas (e.g., performance‑based bonuses) help demonstrate a deliberate, arms‑length approach and are among the factors the IRS considers. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf).

• Implement proper payroll and reporting
  Pay the salary via payroll with federal income tax withholding, Social Security, Medicare, and—when applicable—Additional Medicare Tax. Report wages on Form W‑2 and remit employment taxes on the required deposit schedule. Employers must deposit withheld federal income tax and both employee/employer FICA by electronic funds transfer and report on Forms 941/940 per IRS due dates and schedules. See “Depositing and reporting employment taxes” (https://www.irs.gov/businesses/small-businesses-self-employed/depositing-and-reporting-employment-taxes) and “Additional Medicare Tax Q&A” (https://www.irs.gov/businesses/small-businesses-self-employed/questions-and-answers-for-the-additional-medicare-tax).

Special items to include or coordinate in wages

• Health insurance for >2% shareholders: Premiums paid by the S‑corp for a more‑than‑2% shareholder‑employee are deductible by the S‑corp but must be included in the shareholder’s Form W‑2 (Box 1) for income tax purposes (not subject to FICA/FUTA). This inclusion enables the shareholder’s above‑the‑line self‑employed health insurance deduction, assuming the plan is properly established by the S‑corp. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf).

Compliance checkpoints and reporting

• Form 1125‑E and W‑2 reporting: Entities with total receipts of $500,000 or more must attach Form 1125‑E to report compensation of officers; also ensure wages are properly reported on Forms W‑2 and timely deposited and reported on employment returns. See Instructions for Form 1125‑E (https://www.irs.gov/pub/irs-pdf/i1125e.pdf) and “Depositing and reporting employment taxes” (https://www.irs.gov/businesses/small-businesses-self-employed/depositing-and-reporting-employment-taxes).

• Corporate return timing: Form 1120‑S is generally due by the 15th day of the 3rd month after year‑end and e‑file is required if you file 10 or more returns of any type during the year. Confirm filing obligations and due dates as part of year‑end planning. See 2024 Instructions for Form 1120‑S (https://www.irs.gov/pub/irs-pdf/i1120s.pdf).

Red flags that suggest wages are not reasonable

• Low or zero wages paired with large distributions or shareholder personal expenses paid by the corporation. The IRS warns against reclassifying compensation as distributions or loans when substantial services are performed—those amounts must be treated as wages subject to employment taxes. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf).

• Treating an officer who performs significant services as a non‑employee. Officers providing more than minor services are employees; compensation is wages subject to withholding and employment taxes. See Publication 15‑A (2025) (https://www.irs.gov/pub/irs-pdf/p15a.pdf).

A simple, illustrative framework (example)

• Facts: 100% shareholder‑officer acts as CEO and operations lead; full‑time; $1.8M gross receipts and $350k net income; two managers earn $95k and $110k.

• Market comps: Similar‑sized firms pay CEOs $140k–$200k locally.

• Decision: Set base salary at $160k with performance bonus potential up to $30k. Include >2% shareholder health premiums in W‑2 Box 1 (not subject to FICA) and run payroll with required withholding/FICA/Additional Medicare if thresholds met. Document rationale (duties, time devoted, comparables, profits, payments to non‑owner employees). This aligns with the IRS factors and compliance guidance. The officer’s wages are reported on Form W‑2 and employment taxes are deposited via EFTPS per schedule. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf) and “Depositing and reporting employment taxes” (https://www.irs.gov/businesses/small-businesses-self-employed/depositing-and-reporting-employment-taxes).

Documentation and process best practices

• Keep written job descriptions, time devotion records, and business size metrics (receipts, employees).

• Maintain third‑party compensation data used for benchmarking and any compensation agreements or board minutes approving salary/bonuses.

• Retain proof of payroll withholding, deposits, and filed returns, and include >2% shareholder health premiums appropriately in W‑2 reporting. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf) and “Depositing and reporting employment taxes” (https://www.irs.gov/businesses/small-businesses-self-employed/depositing-and-reporting-employment-taxes).

Bottom line

Pay shareholder‑officers a bona fide wage that reflects their services, duties, time, experience, and market comparables. The IRS looks at the full picture—what services were performed, how much time was spent, what the business pays others, and how similar businesses compensate comparable roles. When in doubt, err on the side of paying a market‑rate salary through payroll with proper withholding and reporting, and document your rationale. This positions your S‑corp to meet the “reasonable compensation” standard and avoid recharacterization of distributions and employment tax exposure. See FS‑2008‑25 (https://www.irs.gov/pub/irs-news/fs-08-25.pdf) and Publication 15‑A (2025), “Who Are Employees?” (https://www.irs.gov/pub/irs-pdf/p15a.pdf).