The S corporation is one of the most popular tax structures for profitable small businesses — and for good reason. But its central tax advantage comes with a rule the IRS takes seriously: if you work in your S corp, you must pay yourself a reasonable salary before taking the rest as distributions. Get that balance wrong, and a smart structure becomes an audit risk.

Why the salary rule exists

Here is the tax math behind the whole issue. Wages you pay yourself are subject to payroll taxes — Social Security and Medicare. Distributions of remaining profit are not. Naturally, that creates a temptation to pay a tiny salary and take everything else as distributions to shrink the payroll tax bill. The IRS knows this, which is why it requires S corp owner-employees to take reasonable compensation for the work they actually perform, before any distributions.

The S corp advantage is real — but it lives entirely in getting the salary right. Too low invites the IRS; too high gives away the benefit. The whole game is the reasonable number in between.

What “reasonable” actually means

Reasonable compensation is what you would have to pay someone else to do the work you do for the business. It is not a fixed percentage, despite the rules of thumb you may have heard. Instead, it is a facts-and-circumstances judgment based on factors such as:

  • Your training, experience and the duties you perform
  • The time and effort you devote to the business
  • What comparable businesses pay for similar roles
  • Your involvement in generating the company’s income
  • What the business can reasonably afford to pay

The risk of getting it wrong

Paying yourself too little is the classic mistake. If the IRS examines an S corp and finds an owner taking large distributions on an unreasonably small salary, it can reclassify those distributions as wages — and assess back payroll taxes, penalties and interest. Reasonable compensation is one of the most frequently examined issues for S corporations, precisely because the incentive to underpay is so common.

Paying yourself too much is a subtler error in the other direction: it works, but it hands back the very payroll-tax savings that made the S election worthwhile in the first place.

How to get it right

The goal is a defensible number — one you can support with documentation if anyone ever asks. That means looking at real compensation data for your role, industry and region, considering your actual duties, and keeping a record of how you arrived at the figure. Reasonable compensation is not something to guess at once and forget; it deserves a fresh look as your business and your role in it change.

If you run an S corporation — or you’re weighing the election and want to understand the salary commitment before you make it — this is exactly the kind of planning we handle for the business owners we work with, so your structure saves what it should without inviting scrutiny it shouldn’t.