Summer is a great time for S-corporation owners to take a step back and review one of the most scrutinized areas of S-corp taxation: reasonable compensation.
Why It Matters
If you operate your business as an S-corporation and provide services to that business, the IRS requires you to pay yourself a “reasonable” salary through payroll before taking any distributions. This salary is subject to payroll taxes (Social Security and Medicare), while distributions are not.
Some owners try to minimize payroll taxes by paying themselves little or no salary and taking the rest of their income as distributions. The IRS is well aware of this strategy, and it remains a top audit trigger for S-corps.
What Counts as ” Reasonable”?
There’s no single formula, but the IRS and courts generally look at factors such as:
- The work actually performed (training, experience, time, and effort devoted to the business)
- What comparable businesses pay for similar services
- The compensation agreements in place
- The use of a formula to determine compensation
- Distributions to non-shareholder employees compared to those made to shareholder-employees
A good benchmark is asking: “What would I have to pay someone else to do what I do for this business?”
Mid-Year Check-In Tips
- Review your salary versus distributions year-to-date. If you’ve taken significant distributions but little or no salary, now is the time to adjust payroll before year-end.
- Document your reasoning. Keep notes on how you arrived at your compensation figure, including any salary surveys or industry data you used.
- Adjust for changes in your role. If your responsibilities have grown (or shrunk), your reasonable compensation amount may need to change too.
- Don’t forget payroll tax deposits. If you increase your salary mid-year, make sure withholding and employer tax deposits stay on track to avoid penalties.
The Bottom Line
Setting a reasonable salary isn’t just about avoiding an audit, it’s about protecting the S-corp election itself and ensuring your retirement contributions, Social Security benefits, and other payroll-based calculations are accurate.
