When your business is organized as an S corporation, you don't have to pay a separate corporate income tax, as you would for a regular C corporation, yet you still enjoy the benefit of limited personal liability. All the taxable income your business makes passes through to the owners, who then add it to their personal tax return. However, like all employers, an S corporation is required to withhold and pay employment taxes for compensation paid to its employees, including bonuses.

Bonuses Are Compensation

Your employees are legally required to be paid for their work, but as their employer, you are free to make any kind of compensation package you wish, provided it doesn't violate fair labor laws. You can pay salary, commissions and bonuses as often as you wish. The frequency or exact formula is up to you. But no matter what you call the compensation, it is all subject to income taxes, payroll taxes and unemployment taxes. This is true for all employees of an S corp, whether they are shareholder-owners or not.

Owner Employee Compensation

It is common for one or more of the owners, the shareholders, to actually perform work for the S corporation. Like any other employee, they are required to be paid compensation for their work and time. However, S corporation owners can also receive money from the business by receiving their proportionate distribution of the revenues earned by the business and by taking a valid and documented loan from the S corporation. A bonus is not a distribution; it's fully taxable compensation. A valid distribution is not subject to payroll or unemployment tax withholding or payments.

Reasonable Compensation Requirement

Owners who perform work for the S corporation must receive what the Internal Revenue Service deems reasonable compensation. There is no hard and fast rule or formula to determine what this amount is. The IRS has this requirement because money paid to the owners as distributions or loans escape payroll and unemployment taxes. The IRS will look at the exact nature of the work the owner-employee performs, what similar employees are paid and other aspects of the compensation. If the IRS determines that the owner-employee isn't being paid reasonable compensation, the agency will reclassify other monies paid to that person as compensation. This results in a bill for unpaid taxes on the amount that's reclassified.

Other Provisions

If the IRS reclassifies money paid as distributions or loans as compensation, penalties and interest will also be due. The job title or description does not control what reasonable compensation is. If the owner-employee is labeled as an executive assistant but carries out the duties of a chief executive officer, he must receive the reasonable compensation of a CEO. Compensation can be actual cash or in-kind, such as products, plane tickets or similar non-monetary payment. The IRS will not rule as reasonable compensation more than the S corporation's revenue.