Separate return on labor from return on ownership
A shareholder may receive both compensation for services and distributions connected with ownership. The labels in the books or bank transfer memo do not control the federal tax treatment when the underlying facts show payment for work performed.
The IRS can reclassify shareholder distributions or other payments as wages to the extent they represent reasonable compensation for services.
Build a contemporaneous compensation file
- Job duties, authority, hours, revenue responsibility, specialized skill, and services provided by other people.
- Compensation history, payroll frequency, bonuses, benefits, distributions, and shareholder loans.
- Comparable compensation evidence matched to industry, location, company size, and responsibilities.
- Board or shareholder approval, analysis date, assumptions, professional review, and any midyear adjustment.
Coordinate the entire year
Review payroll deposits and filings, officer compensation reporting, shareholder health-insurance treatment, retirement-plan compensation, accountable-plan reimbursements, distributions, basis, and cash flow together. A December payroll entry cannot always repair a year of inconsistent operations without consequences.
Reasonable compensation is fact-specific. Use this guide to organize the evidence, not to choose a salary without individualized tax and payroll advice.