S Corp Reasonable Compensation: How to Set a Salary the IRS Will Accept

If you own an S Corporation and work in the business, you are an employee as well as a shareholder. That means you must pay yourself a reasonable salary through payroll before taking distributions. Getting the number wrong is one of the most common S Corporation audit issues.

Why the IRS Looks at Owner Salaries

Salary is subject to payroll taxes, including Social Security and Medicare. Distributions of profit are not. That gap creates an incentive to keep salaries low and take more of the income as distributions.

When the IRS finds that an owner-employee was underpaid, it can reclassify distributions as wages. The result is back payroll taxes, plus penalties and interest. Because the exposure builds up year after year, a low salary you never revisit becomes more expensive over time.

There Is No Fixed Percentage

Neither the tax code nor the IRS sets a formula. Rules of thumb that circulate online, such as a fixed split between salary and distributions, have no official standing. What matters is whether your salary reflects what the business would pay someone else to do the same work.

Factors That Support a Defensible Salary

The IRS and the courts have looked at a range of factors when reviewing owner pay. The most common include:

• Your duties, and the number of hours you work in the business
• Your training, experience, and qualifications
• What comparable businesses pay for similar services
• The size, complexity, and revenue of the company
• What the company pays non-owner employees in similar roles

If you fill several roles, such as operations, sales, and finance, the salary should reflect the combined responsibilities. A business with meaningful profit and an owner who works full time is difficult to defend with a token salary.

Document the Decision

A number without support is hard to defend in an audit. Build a file each year that shows how you arrived at it:

• Compensation data for comparable roles from published salary surveys or government wage data, with the source and date noted
• A written description of your duties and time commitment
• A record of the decision, such as meeting minutes or a signed memo

Revisit the analysis annually, and again after major changes in profit or in your role. Run salary through regular payroll on a consistent schedule, not as a lump sum at year-end.

Common Mistakes to Avoid

Paying no salary at all is the most serious error. Others include setting salary to whatever cash is available, letting distributions far exceed wages without an explanation, and skipping payroll for months at a time. Also check your state’s rules, since some states apply their own requirements to S Corporation owner pay.