For an S corporation — a small corporation that is structured and taxed similarly to a partnership—one of the biggest advantages of this structure is its ability to avoid payment of Social Security and Medicare taxes. However, while this benefit has become very popular among S corporations, it has become decidedly less so for the U.S. Internal Revenue Service.

The key provision at issue is that earnings and profits taken in by an S corporation and distributed to its shareholders are not subject to Social Security and Medicare taxes. Because the owners of an S corporation act as both shareholders and employees, they control not just the distribution of profits, but also the amount of their salaries. By taking low salaries and claiming larger profits as corporate distributions, owners are able to avoid significant taxation. Some S corps, in fact, have taken the approach of paying shareholders nothing at all—or at least nothing they classify as employee salary.

The IRS frowns upon these practices, as they deprive the federal government of significant tax revenue. A 2000 study by the IRS determined that nearly half a million S corporations with single shareholders—in other words, owners beholden to no one when it comes to their salaries—paid no salaries to their owners. This revelation has resulted in the IRS taking a more aggressive approach to identifying and penalizing S corps that fail to pay their shareholders a reasonable salary.

But what constitutes a reasonable salary for an S corporation employee, at least as far as the IRS is concerned? Unfortunately, there is no set dollar amount that will free you from scrutiny. Instead, the agency looks at a variety of factors when determining whether a salary is reasonable or not. Among these factors are the following:

• The specific duties and the level of responsibility shouldered by the employee;
• The time, energy and effort the business demands of its employees;
• Whether salaries were determined using a formula;
• The cost of living in the area in which the business is located; and
• Patterns of payment for employees over time.

After examining these and numerous other factors, the IRS develops a range of salaries it considers reasonable for the job, and whether the employee’s salary is considered reasonable determines if any of the corporate distributions are reclassified as salary and thus subject to taxation.

Naturally, this process can be extremely complicated, particularly as the IRS takes so many factors into consideration. If you’re wondering whether your S corporation is approaching employee salaries in a reasonable and responsible manner, it’s best to seek the guidance of an experienced business law attorney.

Adam N. Marinelli is an attorney in the Civil Litigation Practice Group at BoltNagi PC, a full service business law firm serving the U.S. Virgin Islands.