S-Corp reasonable salary: what the IRS actually expects

If you run an S-Corp and pay yourself only in distributions, you are relying
on the IRS not looking. The rule is that an owner who works in their own S-Corp
is an employee of it, and must be paid reasonable compensation through
payroll before taking distributions. It is one of the most commonly examined
issues for small S-Corps, and it is entirely avoidable.

The reason people get it wrong is that the incentive runs the other way.

Salary carries payroll tax. Distributions do not. That gap is exactly why the IRS cares how you split them.

Where the money actually goes

An owner taking $120,000 out of an S-Corp, split three different ways. The
FICA figures are the employee and employer halves combined, which an S-Corp
owner effectively pays both of.

What counts as reasonable

There is no formula in the statute, which is what makes this uncomfortable.
What exists is a set of factors the courts and the IRS actually weigh:

• What the role would cost to hire. The clearest single test: what
  would you pay someone else to do what you do, at your hours?
• Training, experience and duties. A licensed professional doing
  billable work sits differently from an owner who oversees staff.
• Time actually devoted. Part-time involvement supports a lower
  salary — and it needs to be genuinely part-time.
• What the business can pay. Reasonable compensation is not required
  to exceed what the company earned.
• How other employees are paid. A staff member out-earning the owner
  who does the same work is difficult to explain.

The knock-on effects people forget

1. The QBI deduction. Section 199A can be limited by W-2 wages paid.
   Driving salary to the floor can reduce the deduction and cost more than the
   payroll tax it saved.
2. Retirement contributions. Solo 401(k) and SEP limits are driven by
   W-2 compensation. A very low salary caps how much you can put away.
3. Social Security. Benefits are based on earnings recorded. Years of
   near-zero salary are years of near-zero credit.
4. Borrowing. Lenders look at W-2 income. A $0 salary makes a mortgage
   application harder than it needs to be.

How to fix it if it has been wrong

If the year is still open, the cleanest correction is to run payroll for a
reasonable salary before year end and file the payroll returns properly. If
prior years are already filed, that is a conversation with whoever signs your
return — amended payroll filings and voluntary correction are real options, and
which one fits depends on facts we would want to see first.

What does not work is recharacterising distributions as salary in the
bookkeeping without filing the payroll returns behind them. That produces books
that disagree with the filings, which is worse than the original problem.

This is general information, not tax advice for your situation.
Reasonable compensation is fact-specific and the consequences of getting it
wrong are real, so it is worth an actual conversation rather than a rule of
thumb from a web page.

Questions we get asked