Ensuring Fair and Compliant Compensation for S Corporation Manufacturing Owners
Posted by Kristin Re’ on June 03, 2025
In many small manufacturing businesses structured as S corporations, the owner often wears multiple hats—acting as both a shareholder and an active participant in daily operations. While this dual role is common, it also brings a critical tax consideration: ensuring that the owner receives reasonable compensation for services rendered. Failing to do so can trigger IRS audits, back taxes, and penalties.
Balancing Salary and Distributions
S corporation owners who work in the business can receive income in two forms:
- Wages or salary, which are subject to income and payroll taxes.
- Shareholder distributions, which are not subject to payroll taxes and may be tax-free up to the shareholder’s basis in the company.
This structure can create a temptation to minimize salary and maximize distributions to reduce tax liability. However, the IRS requires that any shareholder-employee be paid a reasonable wage before distributions are made. If compensation is deemed unreasonably low, the IRS may reclassify distributions as wages, resulting in additional taxes and penalties.
How the IRS Assesses Compensation
To determine whether compensation is reasonable, the IRS looks at how the business generates its income. Specifically, it evaluates:
- Whether gross receipts are primarily driven by the shareholder’s personal services.
- The role of non-owner employees, capital, and equipment in generating revenue.
In manufacturing businesses, where machinery, facilities, and team efforts often drive production, a larger portion of income may justifiably be treated as distributions. However, this doesn’t exempt owners from receiving fair compensation for their administrative and leadership roles.
Factors That Influence Reasonable Compensation
The IRS considers a range of factors when evaluating owner compensation, including:
- The owner’s experience, qualifications, and responsibilities.
- Time and effort devoted to the business.
- Compensation paid to non-owner employees.
- Industry benchmarks and comparable salaries in similar businesses.
- The company’s financial performance and dividend history.
Owners who serve as CEO, manage operations, oversee finances, and handle sales or procurement should ensure their compensation reflects the full scope of their contributions—not just their formal title.
Documentation Is Key
If your compensation practices come under IRS scrutiny, you’ll need to justify your salary with solid evidence. This may include:
- Industry salary surveys and benchmarking data.
- Job postings from similar companies.
- Reports from trade associations or the Bureau of Labor Statistics.
- Internal records showing job duties, hours worked, and business performance.
Stay Ahead of Compliance
To avoid costly reclassifications and penalties, manufacturing business owners should regularly review their compensation structure. Ensuring that salaries are aligned with industry standards and supported by documentation can help maintain compliance and reduce audit risk.
If you’re unsure whether your current compensation strategy meets IRS expectations, consulting a Lumsden McCormick tax advisor can provide clarity and peace of mind.
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As a principal in our tax department, Kristin serves businesses and individuals. She works primarily with commercial entities in a variety of industries, including Partnerships, S-Corporations, and C-Corporations. She has also worked extensively with manufacturers and start-up companies. Kristin helps companies obtain various tax incentives to reduce tax liability and improve cash flow. Her focus is on various federal, state, and local business development incentives, including Start-Up New York, Excelsior Jobs Program, New York State Film Tax credits, and Federal Research and Development tax credits. She is involved with Firm recruitment and hiring, is a member of the Lumsden Manufacturing team, and serves as co-chair of the Firm R&D tax credit department.