Must an S-Corporation Pay Salary If the Owner Takes No Money Out of the Business?

Question

Owners of an S-corporation who provide services to the corporation are required to pay themselves a salary. But what if the owner legitimately took no money out of the business?

More specifically, the question is: if an S-corporation ends up with a profit at the end of the year, and the owner of the corporation withdrew no money for himself during the year, must he allocate a portion of the profit to “salary” and pay payroll taxes on that salary?

Example:

Joe the Window Washer forms an S-corporation. Joe’s business has a profit of $40,000 for the year, but Joe is living off savings and took no money out of the business for himself. Must he call a  portion of the $40,000 profit “salary”?

Answer

I’ve debated this with peers several times.

Some of my peers say yes, the owner MUST assign themselves a salary, even if no money was actually withdrawn.

But I say the salary requirement applies only if the owner took money out of the business for themselves. If no money was taken out, there’s no requirement to say that a portion of the profit is salary.

What does the law say?

Tax law says a corporate owner who receives compensation for services must treat some or all of that compensation as salary subject to employment taxes. See Revenue Ruling 74-44, and Code section 3121, among others.

If a business owner legitimately takes no money out of the business, I don’t think there’s a requirement to pay a salary.

In the real world

From a real-world standpoint, it’s rare to find a corporation where the owner is not taking money out for themselves, so the above discussion may be mostly hypothetical.

But I have seen it happen. For example, I once worked with a corporation that was turning a profit but that had fallen way behind on submitting sales tax to the state.

All excess money in the corporation was going towards paying off the back sales taxes. The business owner was married to a spouse who made six-figure income, so the family was living off the spouse’s income while the corporation paid off the sales tax debt.

In other cases, a corporation may be in startup mode or saving money for expansion.

The key in these cases is: 1) in order for there to be no salary, the owner must legitimately not be taking any money out of the corporation, and 2) I think there needs to be documentation of some sort, showing the reason why no wages are being paid right now.