S Corp Salary: What Counts as “Reasonable Compensation”?
Let’s get real. If you run an S corporation and you work in it, the IRS expects you to pay yourself a W-2 salary that fits your role. Not a token number. Not “whatever’s left.” Reasonable. If you skip salary or play games with it, you invite penalties and a painful reclassification of “distributions” into wages. IRS+1
This guide shows you exactly how to set a defensible number, document it, and run it without drama.
First principle: salary before distributions
If you perform services for your S corp, pay yourself wages first. Only then do distributions make sense. The IRS says shareholder-employees must receive reasonable compensation for services before non-wage payouts. IRS
What counts as “reasonable” is facts and circumstances. Duties. Time. Skill. What similar businesses pay for similar work. The IRS even suggests using public compensation sources to find market averages. IRS
Why the IRS cares
Payroll taxes fund Social Security and Medicare. An S corp that pays little or no W-2 wages but large distributions looks like it is dodging employment tax. The IRS can reclassify distributions as wages and assess back taxes, penalties, and interest. This is not theoretical. Courts have upheld the Service when salaries were clearly too low, like in the Watson case out of the Eighth Circuit. U of I Tax School+1
The core rule in plain English
If you’re an officer who provides services, you are an employee for employment tax purposes. Wages apply. IRS
Your S corp must report an appropriate and reasonable salary for you if you receive or have the right to receive cash or property. IRS
“Wages” cover all remuneration for employment, subject to specific exclusions defined in the Code. Legal Information Institute
Translation: pay yourself like you’d pay someone else to do your job at your company.
What the IRS looks at
Across IRS pages, job aids, and case law, these factors show up again and again:
Your training and experience
Your duties and responsibilities
Time and effort devoted to the business
Comparable pay for similar roles in similar markets
Company performance and where revenue comes from
Payments to non-owner employees
Dividend and bonus history
Written compensation agreements and formulas IRS+2IRS+2
Note: the IRS “Reasonable Compensation Job Aid” guides examiners on methods and sources. It is not law, but it shows how they think and what data they consider credible. IRS+1
Kill the myths
Myth: “60/40” is a safe rule. There is no percentage rule in the Code or regs. Salary must fit your facts. IRS
Myth: “I can just take distributions.” Not if you work in the business. Salary comes first. IRS
Myth: “Market data isn’t required.” It is not mandated, but it is how you defend the number. The IRS itself points you to public pay sources. IRS
A simple, defensible way to set salary
You do not need a 30-page report. You need a clear process and a file that would make sense to an auditor.
Step 1: Define your role
List the hats you actually wear this year. CEO, sales, ops, practitioner, project lead, bookkeeper. Estimate weekly hours for each.
Step 2: Pull market pay for each hat
Find what similar roles pay in your region or industry. Use public comp sources the IRS acknowledges are fair to consult. Save screenshots with the date and source. IRS
Step 3: Weight by time
If you spend 60 percent of your week in client-facing work and 40 percent managing, weight the market rates accordingly to get a blended base.
Step 4: Adjust for business dependence
If revenue is driven mostly by your services, lean higher. If revenue is produced by employees or significant capital, note that and temper the number. These are factors the IRS considers. IRS
Step 5: Reality check with company performance
You cannot pay more than the company can afford. But “we can’t afford it” is not a defense if you are pulling large distributions. Note margins, revenue trend, and cash covenants.
Step 6: Set the salary and cadence
Pick a defensible number. Pay it on a predictable schedule, like twice a month. Use payroll. Withhold and deposit correctly using the standard employer rules. SDO CPA
Step 7: Write a one-page memo
Document your role, data sources, time weights, adjustments, final number, and pay cadence. Sign it. Drop it in your corporate records.
Example: blended role calculation
Practitioner work: 25 hours per week. Market rate 65 to 85 dollars per hour in your city. Choose 75.
CEO/GM work: 15 hours per week. Market rate 120,000 to 160,000. Choose 135,000 annual, which is about 65 per hour assuming 2,080 hours.
Weighted hourly: [(25 × 75) + (15 × 65)] ÷ 40 = 71.25 per hour
Annualized base: 71.25 × 2,080 = 148,200
Adjustment: revenue depends heavily on your work. Add 7 percent.
Proposed salary: 158,500 paid twice monthly
Create your memo with the math and links to your compensation sources.
What the Watson case teaches
A CPA paid himself 24,000 in wages while taking much larger distributions. The IRS expert used market data and workload analysis to estimate a salary over 90,000. The court agreed the original salary was unreasonably low and upheld a much higher number. The lesson is not the dollar figure. It is the method and documentation. Journal of Accountancy+1
Red flags that trigger audits
Big distributions with little or no W-2 wages for a working owner
Sudden salary cuts the same year distributions spike
Paying family members generously while underpaying the owner
“We pay what’s left” with no documentation
No payroll deposits or late filings when wages are present
The Service can reclassify distributions as wages and assess employment taxes. They have explicit authority to do so and use it. U of I Tax School
Payroll mechanics you cannot ignore
Once you set salary, run real payroll.
Withhold and deposit federal income tax, Social Security, and Medicare on the correct schedule.
File your quarterly 941s and annual W-2 and W-3.
Follow Publication 15 for employer responsibilities and 15-T for withholding tables. SDO CPA
Boring beats brave here. Automate the deposits and filings.
How to adjust midyear
You can raise salary midyear if the facts change. Maybe your role grows. Maybe profits jump. Update your memo, show the new market data or time allocation, set the new pay rate, and keep going. Avoid whiplash. Do not yo-yo wages every month.
Special situations
Multiple owner-operators
Each working owner needs a salary appropriate to their role. One person might be a practitioner. Another is sales and ops. Document separately.
Seasonal businesses
Set a base salary you can maintain year-round. If needed, pay a year-end bonus tied to performance. Keep the rationale in your memo.
Young S corps with thin cash
If cash is tight, prove it. Show the P&L and cash flow. Pay the most defensible number you can and avoid distributions until salary is current.
Owner pay, distributions, and benefits
Sequence matters.
Pay reasonable W-2 wages for your role. IRS
Fund tax reserves and working capital.
Take distributions of remaining profit in quarterly chunks, not drips.
Layer benefits and retirement in a coordinated way.
This keeps cash predictable, protects your loan covenants, and shows healthy discipline to anyone reading your return.
Documentation checklist for audit defense
One-page compensation memo with role, time split, market sources, math, and final number
Copies of public compensation data with dates and URLs
Board minutes or owner consent approving compensation
Payroll registers, 941s, W-2
Year-end note explaining any midyear changes to role or pay
Quick FAQ
Can my salary be a percentage of profits?
You can use a formula, but it must land on a reasonable number for the services you perform, not just a share of profits. Document why it is reasonable in your facts. IRS
What if I have a loss year?
Loss does not automatically justify zero wages if you worked and took distributions. If cash is truly tight, pay what you can defend and avoid distributions until wages are current. The IRS focuses on services provided. IRS
Can I pay myself later to “catch up”?
Late wage “catch-ups” can be messy and may still draw scrutiny if you took distributions first. Better to set a defensible number and pay steadily.
Action steps for small business owners
Write your compensation memo this week. Keep it to one page.
Collect three market data sources per key role. Save them. IRS
Set a twice-monthly payroll cadence. Automate deposits and filings under Publication 15. SDO CPA
Stop distributions until wages are current. Avoid audit bait. IRS
Calendar a midyear review of role, hours, and salary. Update the memo if facts change.
Train your bookkeeper on the sequence: salary, taxes, reserves, distributions.
If you are behind, fix it now. Reclassify where needed with your CPA and move forward with clean payroll.
Resources
IRS: S corporation compensation and medical insurance issues. Core rule that working shareholders must be paid reasonable compensation before distributions. IRS
IRS: Paying yourself. Plain-English guidance and suggestion to use public compensation sources to gauge wages. IRS
No BS Takeaway
Reasonable compensation is not a trick. It is a process. Define your role, pull market data, blend by time, adjust for how dependent the business is on you, document the number, and pay it on schedule. Do that and you will sleep better, keep the IRS out of your pocket, and run a healthier company.
Want help picking your exact salary and building the memo and payroll plan that backs it up? Book a Black Mammoth Power Hour and we will lock this in, no guesswork. Bring your numbers. I bring the plan. In 60 minutes we set your salary, tax sweeps, and next moves.
You leave with a one-page action plan, dollar amounts, and dates.