At a glance
- What it is
- Setting the salary an S corp owner pays themselves at a level that is reasonable for the work they do, and documenting why.
- Why it matters
- Every salary dollar carries 15.3% payroll tax. Distributions above salary don’t.
- Best fit
- Every S corp owner who works in the business.
- Main catch
- “Reasonable” is a judgment call the IRS can challenge, so the number needs support.
- When to review
- Every year, and any time your role or profit changes significantly.
Key takeaways
- Reasonable compensation is the salary an S corp owner pays themselves for the work they do, set at a defensible level and documented.
- Every S corp owner who works in the business and takes distributions needs a salary to go with them.
- In the illustrative example, moving salary from $90,000 to $70,000 saves about $3,060 in payroll tax, if $70,000 is defensible.
- The catch: there is no IRS formula, and a salary set too low can be recharacterized, with payroll tax, penalties, and interest.
The numbers
Picture an S corp with $150,000 of profit before the owner’s salary. Every $10,000 of salary costs about $1,530 in combined employee and employer payroll tax. Here is how the dial moves:
For illustration purposes. Tax law may change, which may change these calculations slightly.
| Owner salary | Payroll tax (15.3%) | Left for distributions |
|---|---|---|
| $50,000 | $7,650 | $100,000 |
| $70,000 | $10,710 | $80,000 |
| $90,000 | $13,770 | $60,000 |
Moving the salary from $90,000 to $70,000 saves about $3,060 in payroll tax, but only if $70,000 is a salary you can defend for the work you actually do. The table shows payroll tax only; the employer’s share is also deductible to the business, which slightly reduces the net difference.
There is no IRS formula or safe percentage. A 40/60 or 50/50 “rule of thumb” split between salary and distributions is not an IRS rule. The right number comes from your role, your hours, and what the market pays for that work.
Could this strategy work for your business?
In a free tax analysis, your tax strategist checks whether it fits and what it could save, using your real numbers.
How it works
- Define the job. List what you actually do in the business: the work you’d have to hire someone else to cover if you stepped away.
- Price the job. Look at what those roles pay in your market, using wage data, job postings, and what you pay comparable employees.
- Set the salary and run it through payroll. Pay it regularly with tax withheld, not as one lump sum in December.
- Document it. Keep a short written file of how you arrived at the number, and update it each year.
What the IRS looks at
The IRS and the courts weigh factors like these when deciding whether a salary is reasonable:
- Your training, experience, duties, and responsibilities
- Time and effort you devote to the business
- What comparable businesses pay for similar services
- What you pay non-owner employees
- The timing and pattern of bonuses and distributions
Who it fits
- Every S corp owner who works in the business. If you take distributions, you need a salary to go with them.
- Owners who set their salary years ago and haven’t revisited it as the business grew.
- Owners who take no salary at all while taking distributions. That is the most common red flag.
Salary affects more than payroll tax
- Retirement contributions. Employer contributions to a Solo 401(k) or similar plan are figured on your W-2 salary. A salary set too low can cap what you can put away.
- The QBI deduction. The Qualified Business Income deduction (Section 199A) is based on profit after salary, so a higher salary can shrink it. At higher incomes, though, the deduction can be limited by W-2 wages, and salary can help. This is where modeling matters.
- Social Security. Lower wages mean a smaller Social Security earnings record.
Risks to weigh
- Too low. The IRS can recharacterize distributions as wages and assess the payroll tax, plus penalties and interest. Courts have upheld this when owners paid themselves far less than their work was worth.
- Too high. No penalty, but you pay 15.3% on money that could have come out as distributions.
- No documentation. Even a reasonable number is harder to defend if you can’t show how you set it.
How we handle it for clients
With a Cannon & Brown tax plan, we set your salary with a documented rationale, model it against your payroll tax, retirement goals, and QBI deduction, and revisit it every year as part of your quarterly planning. Because our technology keeps your numbers current all year, we can test this strategy against your real numbers and adjust it as your business changes.
Illustrative example. The figures on this page are hypothetical, used to explain how the strategy works. They are not a client and not a promise of results. Payroll tax figures assume wages below the Social Security wage base. This page is educational and is not tax advice for your situation; tax rules and limits change.
Brooks leads Cannon & Brown Tax Advisors, a forward-thinking tax firm serving business owners in Oklahoma and beyond. He builds year-round tax strategies that help business owners keep more of what they earn and reach their goals. More about Brooks
Common questions about S corp reasonable compensation
Is a 60/40 split between distributions and salary safe for an S corp?
No. A 40/60 or 50/50 split is a rule of thumb, not an IRS rule. The right number comes from your role, your hours, and what the market pays for that work.
Can an S corp owner take distributions without a salary?
Taking no salary while taking distributions is the most common red flag. If you work in the business and take distributions, you need a salary to go with them.
Can I pay my S corp salary as one lump sum at year end?
It’s better to run it through payroll regularly with tax withheld, not as one lump sum in December.
Does a lower S corp salary affect my retirement contributions?
It can. Employer contributions to a Solo 401(k) or similar plan are figured on your W-2 salary, so a salary set too low can cap what you put away. Lower wages also mean a smaller Social Security earnings record.
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