Reasonable compensation: how to pay yourself as an S-corp owner

The tax benefit of an S-corporation comes from splitting profit between salary and distributions. The IRS knows that, so it requires shareholder-employees to take a reasonable salary for the services they provide. Get this number right and the S-corp works as intended. Get it wrong and it can undo the savings, plus interest and penalties.

Why it matters

If the IRS decides your salary was unreasonably low, it can treat some or all of your distributions as wages. That means back payroll taxes on both the employer and employee side, plus penalties for failing to deposit and report them.

The best-known example is a 2012 federal appeals case, David E. Watson, P.C. v. United States. An accountant paid himself a $24,000 salary while taking roughly $175,000 to $200,000 a year in distributions from his firm. The courts agreed with the IRS that a reasonable salary for his work was about $91,000 and upheld the additional employment taxes. The lesson wasn't that distributions are bad — it was that the salary has to reflect the work.

What the IRS looks at

IRS guidance lists factors courts have used, including:

• Your training and experience
• Your duties and responsibilities, and the time you devote to the business
• What comparable businesses pay for similar services
• Compensation agreements and the company's history of salaries and distributions
• How much of the company's income comes from your personal services versus employees, equipment or capital

That last point matters. A solo consultant whose revenue comes entirely from their own work should expect a salary that's a larger share of profit than an owner whose business runs on a team and equipment.

Three ways to set the number

1. Market approach

What would you have to pay to hire someone with your skills to do your job? Salary surveys and the Bureau of Labor Statistics' occupational wage data by region are common starting points. This is the approach most small businesses use.

2. Cost approach ("many hats")

Many owners wear several hats: salesperson, project manager, bookkeeper, technician. Estimate the hours spent in each role and apply a market rate to each. Adding them up often produces a more realistic figure than a single job title.

3. Income approach

Used more for larger businesses, this asks what return an independent investor would expect on the company's capital. What's left after that return is attributable to the owner's services.

Whichever method you use, sanity-check the result. A salary that's a tiny fraction of profit for a one-person service business will be hard to defend. A salary that equals all of the profit defeats the purpose of the election.

Document it

A reasonable-compensation file doesn't need to be long. It should include:

1. A description of your role, duties and hours.
2. The market data you relied on, with sources and dates.
3. The method you used and the resulting figure.
4. A note to revisit it each year, or when revenue or your role changes materially.

Then actually run it through payroll — regular paychecks with federal and state withholding, quarterly payroll returns and a year-end W-2. Taking a lump sum in December and calling it salary is a weaker position.

Common mistakes

• Zero salary with large distributions. This is exactly the pattern the IRS looks for.
• Health insurance handled wrong. For shareholders owning more than 2%, health premiums paid by the S-corp should be included in W-2 wages; you may then be able to take the self-employed health insurance deduction on your personal return.
• Distributions without enough basis. Taking out more than your stock basis can create taxable gain.
• Ignoring retirement plan effects. Employer 401(k) contributions are based on W-2 salary, so a very low salary also limits what you can shelter. See Solo 401(k) vs. SEP IRA.

We prepare a written reasonable-compensation study for every S-corp client and revisit it each year, so the number on your W-2 is one you can explain.