What S Corp Owners Need to Know about Reasonable Compensation
05/26/2025
If you're an S corporation owner—or are thinking about electing S corp status for your small business—you've probably heard about the importance of reasonable compensation. But what exactly does that mean? How much should you pay yourself? And what are the IRS consequences if you get it wrong?
This guide demystifies the topic of reasonable compensation, helping you understand the rules, make informed payroll decisions, and avoid costly penalties—all while optimizing your tax savings.
What Is Reasonable Compensation?
According to IRS rules, S corporation shareholders who provide services to the business must be paid “reasonable compensation” before taking distributions.
Reasonable compensation is defined as the amount that would ordinarily be paid for similar services by similar businesses under similar circumstances.
In simple terms: if you work in your business, the IRS expects you to pay yourself like you would pay someone else doing your job.
Why It Matters: The Tax Advantage of S Corps
One of the main tax benefits of an S corporation is that it allows business owners to avoid self-employment tax (15.3%) on profits after reasonable compensation has been paid. Here's how it works:
- You pay yourself a salary, which is subject to payroll taxes (Social Security and Medicare).
- Any remaining profits can be transferred to the owner as a distribution, which are not subject to employment taxes.
💡 Example: Let’s say your business nets $150,000.
- You pay yourself a $70,000 salary.
- The remaining $80,000 is taken as a distribution—saving you over $12,000 in payroll taxes (assuming a 15.3% tax rate).
But here’s the catch: if you try to take a small salary and large distributions to avoid payroll taxes, the IRS may reclassify your distributions as wages—and hit you with back taxes, penalties, and interest.
What the IRS Looks For
The IRS has audited many S corps for underpayment of reasonable compensation. Common red flags include:
- Taking distributions with no salary at all
- Paying yourself below-market wages
- Drastically fluctuating salary without business reason
In audits, the IRS refers to factors listed in IRS internal documents and relevant tax court cases. These factors include:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Compensation agreements
- Use of a formula to determine compensation
How to Determine Reasonable Compensation
There’s no one-size-fits-all number, but three methods are commonly used.
- Market Approach
This approach compares the owner's compensation with salary data for similar positions in comparable companies. It's particularly useful when the owner's role is predominantly managerial.
Compare your job title, industry, and duties to similar roles using salary databases like:
- U.S. Bureau of Labor Statistics (BLS)
- Salary.com
- Robert Half Salary Guide
2. Cost Approach
This method focuses on the value of the owner's contributions to the business, considering the cost of hiring someone else to perform the same duties. It's often referred to as the "many hats" approach, as it can be applicable for owners who handle various tasks.
Estimate the cost to replace you with someone else, based on all job duties and percentage of time spent on each task.
3. Income Approach
This method assesses the business's profitability and the owner's contribution to that profitability, determining a reasonable salary based on the company's financial performance and the owner's impact on it. When the owner performs multiple roles, allocate compensation based on the income generated from each function.
📌 Tip: Keep detailed documentation showing how you arrived at your number. This is key if you're ever audited. We can help you by generating a detailed reasonable compensation analysis designed to withstand IRS audit.
When to Adjust Your Salary
Your reasonable compensation should be reviewed annually or when:
- Your business income significantly increases or decreases
- Your role within the company changes
- You add or reduce staff who take over key functions
What Happens if You Get It Wrong?
Failing to pay a reasonable salary can result in:
- IRS reclassification of distributions as wages
- Back payroll taxes
- Penalties (e.g., failure to file Form 941)
- Interest on unpaid taxes
How We Help Our Clients
We specialize in helping small business owners like you:
- Determine and document a reasonable salary
- Set up compliant payroll systems
- Balance salary and distributions for optimal tax savings
- Stay prepared in case of IRS scrutiny
Let’s Talk
Choosing the right salary for yourself as an S corp owner isn’t just a technical issue—it’s a high-stakes decision that can impact your taxes, audit risk, and peace of mind.
Being proactive now can help you avoid IRS trouble later—and save thousands in taxes in the process.
Need help setting your salary and optimizing your tax strategy? Sign up today for a free discovery call.
