If you are a shareholder/officer of an S-Corporation, it is critical that you understand the IRS expectation on paying yourself as an employee. Many people form S-Corporations with the idea that they will save money on employment taxes by taking most of their income as distributions instead of salary. Needless to say, the IRS frowns on this idea.
The IRS has fought in the courts (and won consistently) for the idea of reasonable compensation for officer shareholders. So what exactly is reasonable compensation.
One of the easiest ways to think of reasonable compensation is the idea of replacement cost. If you, the shareholder, needed someone to fill in for your position for an extended period of time, how much would you need to pay someone to accomplish all of the tasks you do. Another (very similar view) is fair market value. If you, the shareholder, decided to close up shop, how much would you have to pay someone else to do what you were doing.
The IRS uses these ideas when determining whether you are paying yourself what they consider a reasonable salary. They will also look at what your peers make outside your company. If they disagree with you, they will reclassify distributions as salary (and charge you the interest and penalties that go along with the time delay).
Record keeping is important. If you are paying less than what the market value is, you need to be able to show accurately that you were working fewer hours or in a different role with a lower rate of compensation. If you have an officer that does minimal or no work for the company, this can be reported on form 1125-E of the 1120-S, but this definitely needs to be supported with documentation to avoid reclassification of any distributions.
No one denies it would be nice to be able to take all of your income from your s-corporation as distributions and avoid those employment taxes, but it’s better to pay those taxes up front than to be hit with the interest and penalties that will accrue when the IRS comes calling to audit you a few years down the road and reclassifies your distributions as wages