Smaller manufacturing companies often operate as S corporations. In many cases, one of the shareholders (or perhaps the only shareholder) also runs the business.

It’s vital that S corporation owners who work in the business pay themselves “reasonable compensation.” If they don’t, they may attract IRS scrutiny — and possibly incur back taxes, interest and penalties. The reasonableness of a shareholder-employee’s compensation can also be an issue in litigation, particularly when the business’s value is in question.

Compensation vs. distributions

S corporation shareholders who perform services for the business can receive both salaries for their services and distributions as shareholders. Salary compensation is subject to both income and payroll taxes. A distribution, on the other hand, can be taken tax-free, as long as it doesn’t exceed the shareholder’s stock basis in the company.

Note: Because an S corporation’s income, gains, losses and deductions generally pass through to the shareholders, who report the items on their individual tax returns, shareholders pay tax on the business’s income regardless of whether they take distributions from it. But this pass-through income isn’t subject to payroll taxes.

If a distribution exceeds a shareholder’s basis, the excess is taxed at long-term capital gain rates (15% or 20%, depending on the shareholder’s income). And it’s not subject to payroll taxes. Thus, S corporation shareholders can potentially reduce their overall tax liability by minimizing compensation and maximizing distributions.

However, the IRS requires S corporations to pay reasonable compensation to shareholder-employees in exchange for services rendered before making distributions. If the IRS finds that a shareholder-employee hasn’t been paid reasonable compensation, it may reclassify distributions as compensation — which generally will result in the shareholder owing back payroll taxes, interest and penalties.

IRS evaluation

From the IRS’s perspective, the key to establishing reasonable compensation for a shareholder-employee lies in determining the services performed for the S corporation. To do so, the tax agency examines the sources of the business’s gross receipts. Were those receipts primarily driven by the shareholder-employee’s services, nonshareholder employees’ services, or capital and equipment?

To the extent gross receipts are generated by the services of nonshareholder employees and capital or equipment, payments to the shareholder-employee are properly treated as distributions free from payroll taxes. Conversely, to the extent the shareholder-employee’s personal services generate gross receipts, payments to the shareholder-employee should be classified as compensation. This bodes well for many S corporation owners in the manufacturing industry, where capital, equipment and the efforts of the nonshareholder workforce typically drive gross receipts much more than the efforts of a single shareholder-employee.

That’s not the end of the analysis, though. In addition to gross receipts generated directly by the shareholder-employee, the IRS says the shareholder-employee should be subject to compensation treatment for administrative work performed for the other income-producing employees or assets. The theory is that, while an owner may not directly produce gross receipts, he or she nonetheless assists other employees or assets that produce the day-to-day gross receipts.

So how do you determine reasonable compensation for an owner’s administrative and other work? Relevant factors include the:

• Owner’s training and experience,
• Owner’s duties and responsibilities,
• Time and effort the owner devotes to the business,
• Company’s dividend history,
• Payments to nonshareholder employees,
• Timing and manner of paying bonuses to key people, and
• Compensation that comparable manufacturing businesses pay for similar services.

It’s not uncommon for the owner of a smaller manufacturing company to wear several hats, of course. You might be CEO, CFO and CMO. Maybe you handle sales, procurement and basic bookkeeping. Your compensation should reflect all these responsibilities, not just the ones in your formal job description.

Prepare now

If you fall onto the IRS’s radar, you must demonstrate that your salary is reasonable — and that your distributions aren’t disguised compensation. You’ll need supporting documentation, including compensation surveys from manufacturing trade associations, competitors’ job listings and data from the U.S. Bureau of Labor Statistics, with adjustments reflecting company-specific factors (such as age, profitability, location and economic conditions).

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