An S corp pays its sole shareholder-officer $15,000 in wages and $120,000 in distributions for a year of full-time work. The IRS recharacterizes $95,000 as wages and assesses FICA plus penalties. Reasonable compensation is not optional.
§162(a)(1) deducts "a reasonable allowance for salaries or other compensation for personal services actually rendered." Three prongs: ordinary (common in the trade), necessary (helpful and appropriate), reasonable (what an arm's-length employer pays for the same work). Courts weigh duties, qualifications, comparable pay, and salary-to-revenue ratios.
C corp owners overpay themselves to strip earnings at the 21% deductible level; excess becomes a nondeductible constructive dividend taxable to the shareholder. S corp owners do the opposite, taking thin wages and large distributions to dodge FICA. Officers rendering more than minor services must take reasonable W-2 wages before any distribution.
HIGH-FREQUENCY: Low-wage, high-distribution S corp facts mean recharacterization. The IRS uses Rev. Rul. 74-44 and Watson v. Commissioner to set a defensible wage.
Employer-paid fringes are deductible under §162 unless a Code section says otherwise. Employee exclusion follows §132:
Common mistakes
- Treating S corp distributions as wage substitutes. Reasonable W-2 wages come first; the rest gets recharacterized with FICA.
- Applying the child-under-18 FICA exemption to a child working for the parent's S or C corporation. Exemption needs a sole prop, disregarded LLC, or parent-only partnership.
- Deducting employer-paid qualified transportation fringes after 2017. Employee-excluded but employer-nondeductible under §274(a)(4).
Bottom line
- §162 deducts compensation only if ordinary, necessary, and reasonable; C corp excess becomes a constructive dividend
- S corp working shareholders take reasonable W-2 wages first, then distributions, or the IRS recharacterizes the shortfall with FICA
- Family payroll breaks apply only in sole props, disregarded LLCs, or parent-only partnerships: child <18 no FICA, child <21 no FUTA, spouse no FUTA, parent of owner no FUTA
- Statutory employees (§3121(d)(3), four categories) get W-2 box 13 checked, file Schedule C, owe no SE tax, no FIT withheld
Exam shortcut
Sole-prop owner + minor child = no FICA AND no FUTA. Any incorporation kills both. "S corp shareholder, no salary, big distributions" = recharacterization with FICA. Highest-probability EA Part 2 distractor. Personally owned property rented to own active business = self-rental. Income nonpassive, loss passive. One-way.
The full lesson (about 1,348 words, 9 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2
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