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.
S-Corp owners can pay themselves in two ways:
• 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.
The IRS requires that owners performing substantial services must receive a salary first—only after paying yourself a reasonable wage can you take distributions.
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))
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.
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.
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
There are three IRS-accepted methods to help you determine and document reasonable compensation:
• 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.
• 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.
• 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.
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.
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.
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.