The IRS reclassified $45,000 of his S-Corp distributions as wages. He owed $6,885 in back payroll taxes, plus penalties and interest. Total damage: over $9,000. His reasonable salary? $0.
The IRS is aggressive about reasonable compensation. Every S-Corp audit includes a reasonable compensation analysis. Zero salary with large distributions is a guaranteed red flag.
This guide will help you set a defensible salary and avoid the audit trap.
Key Takeaways
- IRS requires S-Corp shareholder-employees receive “reasonable compensation” before taking distributions
- Reasonable salary must reflect market rate for services actually performed
- The “60/40 rule” (60% salary, 40% distributions) is a myth – there’s no IRS-approved ratio
- IRS factors: training, experience, duties performed, time spent, comparable wages, company size/profits
- Setting salary too low triggers IRS audit risk; distributions can be reclassified as wages + penalties
- Setting salary too high wastes payroll taxes and reduces QBI deduction eligibility
- Documentation is critical: job descriptions, comparable salary data, time records
- The right salary depends on YOUR specific situation, not a formula
Table of Contents
What is Reasonable Compensation?
The term gets thrown around constantly in S-Corp discussions. But what does it actually mean?
The IRS Definition
Reasonable compensation is the amount that would ordinarily be paid for similar services by a like enterprise under like circumstances.
In plain English: What would you pay someone else to do your job?
The compensation must be paid for services actually performed. You can’t pay yourself for work you don’t do, and you can’t avoid paying yourself for work you do.
Why the IRS Cares
S-Corp structure can eliminate 15.3% self-employment tax on distributions. That’s the whole point. But the IRS wants to ensure shareholder-employees pay appropriate payroll taxes on the value of their labor.
Zero salary + large distributions = obvious tax avoidance. The IRS sees this pattern constantly and pursues it aggressively.
The Core Tension
Here’s the challenge every S-Corp owner faces:
- Lower salary = more SE tax savings (good for you)
- Lower salary = higher audit risk (bad for you)
The goal is finding the defensible middle ground. A salary low enough to provide meaningful tax savings, but high enough to withstand IRS scrutiny.
What Reasonable Compensation is NOT
Let’s clear up common misconceptions:
- Not a percentage of revenue or profit. The IRS doesn’t care about ratios.
- Not whatever you want to pay yourself. Your preference doesn’t matter.
- Not the minimum to “get by.” Personal cash needs are irrelevant.
- Not based on living expenses. What you need doesn’t determine what’s reasonable.
Reasonable compensation is based on market value for your services. Period.
The 60/40 Rule Myth
You’ve probably heard it: “Pay yourself 60% as salary, take 40% as distributions.” It sounds official. It’s not.
Where It Came From
The 60/40 rule is industry shorthand that somehow became gospel. Some accountants use it as a starting point for client discussions. It gets repeated in articles, forums, and conversations until people think it’s actual IRS guidance.
It’s not.
Why It’s NOT an IRS Rule
No revenue ruling, no court case, no official IRS guidance establishes this ratio. The IRS evaluates each case on specific facts.
The ratio that works for one business may completely fail for another.
The Danger of Relying on Ratios
Consider two S-Corps, both with $100,000 profit:
S-Corp A: Retail Business
- Owner manages store, handles basic operations
- Comparable salary: $45,000
- 40% salary ($40,000) might be reasonable
S-Corp B: Specialized Surgeon
- Owner performs complex surgeries
- Comparable salary: $400,000+
- 40% salary ($40,000) is absurdly low
Same profit, same ratio, completely different outcomes. The surgeon’s $40,000 salary would trigger immediate IRS scrutiny. The retailer’s might pass.
What Actually Matters
Forget ratios. Focus on:
- Market rate for your services. What does this job actually pay?
- Replacement cost. What would you pay someone else to do your work?
- Comparable salaries. What do similar positions earn in your industry and location?
- Your specific qualifications. How do your skills affect market value?
Pull Quote: “I’ve seen IRS agents laugh at the 60/40 defense. They want to know what you’d pay a replacement.”
IRS Reasonable Compensation Factors
When the IRS evaluates reasonable compensation, they consider these official factors (from guidance and court cases):
1. Training and Experience
- Education, certifications, professional degrees
- Years of experience in your industry
- Specialized skills or expertise
- How these qualifications affect your market value
A CPA with 20 years of experience commands different compensation than someone fresh out of school.
2. Duties and Responsibilities
- What do you actually DO in the business?
- Decision-making authority
- Risk and complexity of your work
- Management responsibilities
- Technical vs. administrative work
Document your actual duties. “I run everything” isn’t sufficient.
3. Time and Effort Devoted
- Hours per week
- Full-time vs. part-time involvement
- Seasonal variations in workload
- On-call or 24/7 availability requirements
A business owner working 60 hours weekly warrants different compensation than one working 15 hours.
4. Comparable Wages
- What do similar positions pay in your market?
- Industry salary surveys
- Job posting data for similar roles
- Bureau of Labor Statistics wage data
This is often the most important factor. What’s the market rate?
5. Company Size and Complexity
- Gross receipts/revenue
- Number of employees
- Complexity of operations
- Geographic scope (local vs. national vs. international)
Managing a $5 million business with 20 employees is different from running a $200,000 solo operation.
6. Economic Conditions
- Industry health
- Local market conditions
- Company profitability
- Growth vs. decline trajectory
A struggling business in a declining industry might justify lower compensation.
7. Dividend/Distribution History
- Ratio of wages to distributions over time
- Consistency of compensation patterns
- Sudden changes in salary/distribution split
Dramatic changes raise red flags. If you paid yourself $80,000 for years and suddenly drop to $30,000 while profits increase, expect questions.
8. Compensation Agreements
- Written employment agreements
- Board resolutions documenting compensation decisions
- Formal salary setting processes
Documentation matters. Written agreements carry more weight than verbal understandings.
Documentation Tip: Keep records showing how you considered each of these factors when setting your salary.
How to Determine Your Reasonable Salary
Here’s a practical process for establishing defensible compensation:
Step 1: Document Your Role
Start by clearly defining what you do:
- Write a detailed job description
- List all duties and responsibilities
- Estimate hours per week or month for each function
- Note specialized skills required for your role
Be specific. “CEO” is a title, not a description. What does that actually involve for YOUR business?
Step 2: Research Comparable Positions
Gather market data on similar roles:
Sources to use:
- Bureau of Labor Statistics (bls.gov)
- Salary.com, Glassdoor, PayScale
- Industry-specific salary surveys
- Job postings for similar roles in your area
Search for positions matching your actual duties, not just your title.
Step 3: Adjust for Your Specific Factors
Market data gives you a starting point. Adjust for:
- Location: Cost of living differences matter. A marketing manager in San Francisco earns more than one in Des Moines.
- Company size: Larger companies typically pay more for equivalent roles.
- Your qualifications: Advanced degrees, certifications, and specialized experience increase value.
- Years of experience: Entry-level vs. senior-level compensation differs significantly.
Step 4: Consider Multiple Roles
Many S-Corp owners wear multiple hats. You might be:
- CEO (strategic decisions)
- CFO (financial management)
- Sales director (client relationships)
- Operations manager (day-to-day running)
Value each role performed. A reasonable approach:
| Role Performed | Hours/Week | Comparable Salary | Allocated Value |
|---|---|---|---|
| CEO/Management | 15 | $120,000 | $45,000 |
| Sales/Marketing | 10 | $65,000 | $16,250 |
| Operations | 15 | $55,000 | $20,625 |
| Total | 40 | — | $81,875 |
This builds a documented rationale for your salary.
Step 5: Document Your Analysis
Create a written reasonable compensation study:
- Written analysis of how you determined salary
- Comparable salary research (with dates and sources)
- Screenshots of job postings
- BLS data printouts
- Industry surveys referenced
Keep this documentation for at least 6 years (IRS audit window).
The QBI Deduction Impact
Setting salary isn’t just about avoiding IRS problems. It also affects your Qualified Business Income deduction.
How Salary Affects QBI
Section 199A allows a 20% deduction on qualified business income. But here’s the catch:
- S-Corp salary is NOT QBI-eligible
- Distributions ARE QBI-eligible
- Higher salary = lower QBI deduction
This creates a trade-off with self-employment tax savings.
The Trade-Off Math
Example: $150,000 S-Corp Profit
| Salary Level | SE Tax Savings | QBI Deduction Lost | Net Impact |
|---|---|---|---|
| $60,000 | $10,076 | $0* | +$10,076 |
| $75,000 | $8,218 | $3,000 | +$5,218 |
| $90,000 | $6,360 | $6,000 | +$360 |
*Assumes full QBI deduction available on distributions
Finding the Sweet Spot
Generally, SE tax savings outweigh the QBI impact. But extremely low salaries can flip the math.
For high-income taxpayers, the QBI deduction phases out entirely for certain service businesses. In those cases, the trade-off calculation changes.
W-2 Wage Limitation
For high earners in service businesses, QBI is limited by W-2 wages paid. Higher salary actually increases the W-2 wage limitation, potentially enabling more QBI.
The interactions are complex. Model your specific numbers rather than relying on rules of thumb.
What Happens If Salary Is Too Low
The consequences of unreasonably low compensation are severe.
IRS Reclassification
The IRS can reclassify distributions as wages. When they do:
- Employer FICA: You owe 7.65% on reclassified amount
- Employee FICA: You owe another 7.65% on reclassified amount
- Total: 15.3% on the amount reclassified
Plus, you don’t get the benefit of the employer portion being deductible as it would have been if properly paid as salary.
Penalties and Interest
Beyond the tax itself:
- Failure to deposit penalty: 2-15% of unpaid amounts
- Failure to file penalty: 5% per month for unfiled payroll returns
- Interest: Currently around 8% annually on underpayments
- Accuracy-related penalty: 20% of underpayment for negligence or substantial understatement
Real-World Example
Scenario: $100,000 in distributions, $0 salary. IRS reclassifies $60,000 as wages.
| Item | Amount |
|---|---|
| Back employer FICA | $4,590 |
| Back employee FICA | $4,590 |
| Failure to deposit penalty (10%) | $918 |
| Interest (2 years at 8%) | $1,469 |
| Total Additional Cost | $11,567 |
Plus the stress, professional fees to respond to the audit, and potential ongoing IRS scrutiny.
Cases the IRS Has Won
The IRS prevails in these cases regularly:
- Watson v. Commissioner: CPA with $24,000 salary on $203,000 distributions. IRS won.
- Nu-Look Design: Shareholders taking zero salary. IRS won.
- Multiple cases with salary-to-profit ratios below 10%. IRS consistently wins.
What Triggers an Audit
Red flags that invite scrutiny:
- Zero salary with any level of distributions
- Dramatic salary decreases while profits increase
- Salary far below industry norms for your role
- Inconsistent year-over-year patterns without explanation
What Happens If Salary Is Too High
While low salary gets more attention, high salary has costs too.
Wasting Payroll Taxes
Every dollar of salary above “reasonable” costs you 15.3% in unnecessary payroll taxes. There’s no tax benefit for overpaying yourself.
Reducing QBI Deduction
Higher salary means lower QBI-eligible income. You could lose 20% of the excess in foregone deduction.
Cash Flow Issues
Salary requires timely payroll tax deposits. Unlike distributions (which you control), salary creates rigid quarterly obligations. Setting salary too high creates cash flow constraints.
When High Salary Makes Sense
Sometimes higher salary is strategic:
- Maximizing retirement contributions: Solo 401(k) employer contributions are based on W-2 salary. Higher salary enables larger contributions.
- Mortgage qualification: Lenders want W-2 income. Higher salary helps with mortgage approval.
- State-specific benefits: Some state programs key off W-2 wages.
S-Corp Retirement & 401(k) Guide
Documentation Requirements
Documentation is your defense in an audit. Keep these records:
Job Description
- Detailed list of your duties
- Hours devoted to each
- Skills required
- Decision-making authority
- Update annually as role changes
Comparable Salary Research
- BLS data printouts (dated)
- Salary survey results
- Job postings with similar requirements (screenshot with date)
- Industry benchmarks
- Geographic comparisons
Written Analysis
- How you determined your salary
- Factors you considered
- Sources you used
- Date of analysis
- Rationale for adjustments from market data
Board Resolution (If Applicable)
If your S-Corp has formal governance:
- Formal approval of compensation
- Documented rationale for the amount
- Signed and dated by board/shareholders
Annual Review Documentation
- Record of any salary adjustments
- Reasons for changes
- Updated market data
- Notes on industry changes or role changes
How Long to Keep Documentation
- Normal audit window: 3 years from filing
- Extended (>25% income understatement): 6 years
- Safe practice: Keep documentation for at least 6 years
Special Situations
Certain situations require additional consideration.
Multiple Shareholder-Employees
Each shareholder-employee needs their own reasonable compensation analysis:
- Different duties = different salaries justified
- Evaluate each person individually
- Distributions must still be proportional to ownership (not salaries)
Part-Time Involvement
If you work part-time in your S-Corp:
- Salary should reflect actual hours
- Pro-rate from full-time comparable position
- Document your time commitment clearly
A 20-hour-per-week CEO shouldn’t earn the same as a 60-hour-per-week CEO.
S-Corp with Minimal Profits
Tricky situation. If your S-Corp barely breaks even:
- Salary is still required if you perform services
- Salary may equal or exceed entire profit
- This can create a business loss
- Consider: Is S-Corp election still appropriate?
If compliance costs and required salary consistently exceed profit, S-Corp status may not make sense. Review our LLC vs S-Corp Comparison to evaluate whether switching back makes sense.
First Year of S-Corp Election
In your first S-Corp year:
- Pro-rate salary for the portion of year with S-Corp status
- Set up payroll before year-end
- Issue at least one paycheck to shareholder-employees
Frequently Asked Questions
What is reasonable compensation for an S-Corp owner?
Reasonable compensation is the amount you’d pay someone with similar skills to perform the services you provide to your S-Corp. It’s based on market rates, not a formula. Research comparable positions, document your analysis, and consider IRS factors like experience, duties, and industry norms.
Is the 60/40 rule real?
No. The 60/40 rule (60% salary, 40% distributions) is not IRS guidance. It’s industry shorthand that became a myth. The IRS evaluates each case based on specific facts. A ratio that works for one business may fail for another.
What factors does the IRS consider?
Training/experience, duties performed, time devoted, comparable salaries, business size, economic conditions, dividend history, and compensation agreements. See our detailed breakdown above.
How do I document reasonable compensation?
Create a written analysis with: detailed job description, comparable salary research (BLS data, job postings), factors you considered, and the rationale for your salary level. Keep this documentation for at least 6 years.
What if my S-Corp has low profits?
Salary is still required if you perform services. In low-profit years, salary may equal or exceed profit, resulting in a business loss. If this happens consistently, evaluate whether S-Corp status still makes sense.
Can I take only distributions and no salary?
No. If you perform services for your S-Corp, you must receive reasonable compensation. Zero salary with distributions is an automatic audit trigger. The IRS can reclassify distributions as wages with penalties and interest.
How does salary affect the QBI deduction?
S-Corp salary is not eligible for the QBI deduction. Higher salary = lower QBI deduction. However, SE tax savings usually outweigh this impact. Model your specific situation to find the optimal balance.
What if I’m audited on reasonable compensation?
Present your documentation: job description, comparable salary research, written analysis. If you’ve done the work upfront, you’ll have a defensible position. If you haven’t, consider engaging a CPA to prepare a reasonable compensation study.
Do I need to pay myself a salary every year?
If you perform services for your S-Corp, yes. The amount may vary based on profits, but zero salary is not acceptable. Even in low-profit years, pay at least a minimal salary through proper payroll.
Can I change my salary during the year?
Yes, but document why. Salary changes should reflect business changes (new duties, profitability shifts, market conditions). Dramatic mid-year decreases right before large distributions will raise IRS flags.
Next Steps
Protect Yourself:
- Document your analysis: Create a written reasonable compensation study
- Research comparable salaries: Use BLS data, salary surveys, job postings
- Model the trade-offs: Use our S-Corp Calculator
- Review annually: Update your analysis each year
This is the #1 S-Corp audit issue. We’ve helped hundreds of S-Corp owners determine defensible salaries. Our approach: analyze your specific situation, document the rationale, and optimize the salary/distribution split.
If you’re unsure about your current salary or want a professional reasonable compensation analysis, we can help. A well-documented salary protects you from IRS reclassification and ensures you’re getting the tax savings S-Corp election is supposed to provide.