Understanding S-Corp Compensation: What You Need to Know

Why Reasonable Compensation Matters?

As an S-Corporation owner actively working in your business, you wear two hats: employee and shareholder. This dual role means you must pay yourself a reasonable salary for the work you perform before taking any profit distributions. Why? Because the IRS scrutinizes S-Corp compensation to ensure owners aren’t avoiding payroll taxes by taking only distributions. Missteps can lead to audits, reclassification of income, and costly penalties.

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  💵Salary vs. Distributions

  S-Corp owners can pay themselves in two ways:

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  • Salary (W-2 wages): Subject to payroll taxes, including Social Security, Medicare, and federal and state income tax withholding.

  • Distributions: Profit payouts that are not subject to payroll taxes but are still taxed as income.

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  The IRS requires that owners performing substantial services must receive a salary first—only after paying yourself a reasonable wage can you take distributions.

   

   

  💲What Is “Reasonable Compensation”?

   

Rather than applying a rigid formula, the IRS determines “reasonable compensation” by reviewing each situation individually, taking into account all relevant facts and circumstances.

The IRS specifies that reasonable compensation means:

“The value that would ordinarily be paid for similar services by similar businesses under similar conditions.”
(IRS Code Section 162-7(b)(3))

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  In Practice:

Reasonable compensation is essentially what you would pay a qualified individual to perform your job if you weren’t the owner. This should reflect all the roles you fill—such as CEO, bookkeeper, salesperson, and technician.

Important factors to consider are:

• The specific duties and responsibilities of your position

• The time and effort you invest in the business

• Typical compensation rates for similar roles within your industry

• Your background, experience, and education

• The profitability and size of your business

• How much non-owner employees are paid for comparable work.

This is not a one-size-fits-all calculation. It requires thoughtful analysis based on your unique business model and professional profile.

It’s important to note that while some people reference the “60/40 rule” (60% salary, 40% distributions), the IRS does not recognize this method, and relying on it can be risky.

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  💡Why It Matters

   

  As an S-Corp owner, you’re legally required to pay yourself a reasonable W-2 salary before taking any profit distributions—it’s not optional. Ignoring this rule can have serious consequences, including:

   

  • IRS audits or having your distributions reclassified as wages

  • Owing back taxes, plus penalties and interest

  • Potential loss of your S-Corp status

  • Possible preparer penalties for tax professionals

   

  Ensuring compliance not only keeps you in good standing but also protects the valuable benefits of your S-Corp.

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  IRS Guidelines and Common Mistakes

IRS Red Flags to Avoid:

• Taking profits exclusively as distributions without issuing yourself a salary

• Setting your salary below what’s considered standard for your role and industry

• Using arbitrary formulas (such as a 50/50 or 60/40 split between salary and distributions)

• Failing to keep records detailing how you determined your salary

Common Mistakes S-Corp Owners Make:

• Not processing payroll through a proper payroll system

• Overlooking state payroll tax obligations

• Incorrectly categorizing payments (e.g., as distributions instead of wages)

• Paying yourself excessively high salaries, which can reduce your overall tax efficiency

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  • 🧮How to Determine Reasonable Compensation

    There are three IRS-accepted methods to help you determine and document reasonable compensation:

     

    1. Cost Approach

    • Break down the time you spend in each role (for example, 40% on admin, 30% on client work, 30% on marketing).

    • Assign an appropriate market wage to each role.

    • Multiply your hours by the corresponding wage rates to arrive at a blended compensation total.

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    • • 2. Market Approach

        • Based on industry wage data for similar roles. Refer to wage data from reputable sources such as:

        - Bureau of Labor Statistics (BLS)

        - U.S. Census Bureau

        • Compare your position and responsibilities to similar roles in your industry and region to determine a fair salary.

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    3. Income Approach

    • Take into account your business’s profitability and the value you bring as an owner.

    • This method is most used when the business generates significant profits or when your contributions are particularly strategic.

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    📌Best Practices for Compliance

     

    To ensure compliance and make the most of your tax benefits:

    • Run payroll through an official system: Use platforms like Patriot, ADP, Gusto or QuickBooks Payroll to process your salary.

    • Keep thorough records: Document how you set your salary, including relevant market data, descriptions of your job responsibilities, and time logs.

    • Review your compensation annually: Update your salary as your business grows or your role changes.

    • Seek advice from a tax professional: This becomes especially important as your company expands, or your duties evolve.

    • Avoid arbitrary formulas: Use established methods such as the “many hats” approach commonly recommended for small businesses.

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    🎯Striking the Right Balance: Tax Savings and Compliance

    Deciding how to pay yourself as an S-Corp owner requires a careful strategy. While taking distributions can provide appealing tax savings, it’s essential to pair them with a reasonable salary to stay on the right side of IRS requirements. By adhering to best practices and thoroughly documenting your compensation decisions, you can maximize your S-Corp benefits while remaining compliant and prepared for any potential audit.

     

     

Ready to Protect Your S-Corp Status?

Let AllTax Accounting help you stay compliant and confident.
We offer Reasonable Compensation analysis as part of our entity tax planning and compliance services.

📩 Contact us today to schedule your review or include it in your next tax engagement.