A reasonable salary for an S-corp owner is roughly what your business would have to pay an outside hire to do the work you do. The IRS doesn’t publish a percentage or a safe number, so the salary that holds up is one you can back with market pay data for your role, hours and experience. Most owners can find that number in an afternoon. The ones who get into trouble skip the step and pick whatever keeps payroll tax lowest.
If you haven’t elected yet, start with LLC vs S-corp: when the election saves you money. This guide is for owners who are already an S-corp, or about to be, and need to pick the number.
What does the IRS say about reasonable compensation?
Less than you’d hope, but the core of it is clear:
- If you work in the business, you’re an employee. An officer of a corporation is an employee for federal employment tax purposes. Owning the stock doesn’t change that. Your pay for that work is wages, run through payroll, with withholding and a W-2.
- There’s no formula. The IRS’s own page on S corporation compensation says there are no specific guidelines for reasonable compensation in the Code or the regulations. Courts decide it on the facts of each case.
- Distributions can be turned into wages. If you take distributions in place of a reasonable salary, the IRS can reclassify them as wages and assess the payroll taxes that should have been paid.
IRS Fact Sheet 2008-25 lists the factors courts have used. It’s old and marked as historical, but it’s still the list practitioners work from:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend (distribution) history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to set pay
Read that list as one question: would an outside person doing your job, with your background, accept this pay? If the answer is “not a chance,” the salary is too low.
How much salary is enough? Two methods that hold up
An IRS job aid written for its own valuation staff describes three ways to test owner pay. It isn’t official IRS guidance, but it shows how an examiner will think about your number. Two of the three are practical for a small business.
Method 1: the market rate for your main job
This is the approach the job aid calls the most common. Find what employers in your area pay for the job you mostly do, and start there.
- Write down the role that takes most of your week: HVAC technician, dental hygienist, software developer, general manager, bookkeeper.
- Look it up in the Bureau of Labor Statistics wage data, which publishes pay by occupation for every state and most metro areas. Industry salary surveys and real job postings in your area are good second sources.
- Adjust for your experience and hours. A 15-year veteran working 50 hours a week shouldn’t use the entry-level figure.
- Save a screenshot or PDF of what you used, with the date.
Method 2: the “many hats” breakdown
Most small-business owners don’t do one job. They do field work, sell, manage people and handle the back office. The job aid calls this the cost approach: split your time across your roles, price each one at market rates, and add it up. It takes a little longer, but it’s often more accurate for an owner who wears several hats, and it’s easy to explain if anyone asks.
| Method | Works best when | What to keep on file |
|---|---|---|
| Market rate for your main job | You mostly do one kind of work (a consultant, a therapist, a developer) | The wage data you used and the date you pulled it |
| Many-hats breakdown | You split your week across technical work, management and admin | Your time estimate by role, and the rate source for each role |
Neither method needs to be precise to the dollar. You’re building a range you can defend, then picking a number inside it.
A worked example: two salary levels for an HVAC owner
Say an HVAC company run as a single-owner S-corp makes $150,000 a year before the owner’s pay. This is a hypothetical example, and the pay figures are made up for illustration. Use real wage data for your own area.
The owner’s week, by the many-hats method:
| Role | Share of time | Assumed market pay (full-time) | Weighted |
|---|---|---|---|
| Field technician | 50% | $62,000 | $31,000 |
| Operations manager (scheduling, estimating, crew) | 30% | $95,000 | $28,500 |
| Office and admin | 20% | $45,000 | $9,000 |
| Reasonable salary | $68,500 |
Now compare that with the salary the owner was tempted to pick, $45,000:
| Salary of $45,000 | Salary of $68,500 | |
|---|---|---|
| Social Security and Medicare (15.3%, both halves) | $6,885 | $10,481 |
| Extra payroll tax per year at the higher salary | $3,596 | |
| Without the S-corp: self-employment tax on $150,000 | $21,194 | $21,194 |
| Payroll tax saved vs. no S-corp, before payroll and compliance costs | $14,309 | $10,713 |
Two things stand out. First, the defensible salary still saves about $10,700 a year in payroll-type taxes compared with no S-corp (the self-employment tax is 15.3% of 92.35% of profit). Second, the low salary buys only about $3,600 more a year. If an examiner later decides the right number was $68,500, the owner owes the payroll tax on the $23,500 gap for every open year, plus penalties and interest. For three years, that’s $70,500 of reclassified wages and about $10,790 of tax before penalties.
These figures are before income-tax effects, such as the deduction for the employer half of payroll tax and the qualified business income deduction, and before state taxes. The S-corp tax calculator uses a 50% salary as a rough default. Your own number should come from your role, not from a percentage.
What happens if your salary is too low?
If the IRS examines the return and finds your salary unreasonably low, it can treat part of your distributions as wages. That means:
- Back Social Security and Medicare tax on the reclassified amount, both the employee and employer halves
- Penalties for failing to deposit and report the tax, plus interest
- Amended payroll filings and corrected W-2s
The best-known case is David E. Watson, P.C. v. United States (8th Cir. 2012). A CPA paid himself a $24,000 salary from his S-corp and took far more as distributions. The court accepted the government’s expert, who put reasonable pay at about $91,000, and the extra $67,044 a year was subject to payroll tax. The court also said the owner’s intent to keep wages low didn’t matter. What mattered was whether the payments were really pay for his work.
The pattern examiners notice is simple: little or no salary, big distributions, and an owner who clearly runs the business full time.
How do you put the salary on payroll?
A reasonable salary only counts if it’s paid as wages. A journal entry at year-end doesn’t do it. Here’s what has to happen:
- Set up payroll for the S-corp, with a W-4 for yourself and state withholding and unemployment accounts where your state requires them.
- Pay yourself on a regular schedule. Monthly or twice a month is common for an owner-only company.
- Deposit the taxes you withhold, plus the employer share, on the IRS schedule. Most small payrolls start as monthly depositors.
- File Form 941 every quarter. The form is due the last day of the month after each quarter, moved to the next business day when that falls on a weekend. For 2027 that means April 30, August 2, November 1 and, for the fourth quarter, January 31, 2028. See the IRS employment tax due dates.
- Issue your W-2 by January 31 (February 1 in 2027, because January 31 is a Sunday), along with Form 940 for federal unemployment tax.
- Take distributions after that, from profit that’s left, and record them in the books as distributions, not as wages or expenses.
If the S-corp pays your health insurance, the premiums also have to land on your W-2 (box 1) before year-end. That’s the step owners most often miss in December.
How are distributions different from salary?
| Salary | Distributions | |
|---|---|---|
| How it’s paid | Through payroll, with withholding | A transfer from the business account |
| Social Security and Medicare | Yes, 15.3% split between you and the company | No |
| Income tax | Yes, withheld from each paycheck | Yes, on your share of profit, whether or not you take it out |
| Where it shows up | Your W-2 | Your Schedule K-1 and the books |
| Business deduction | Yes | No |
Distributions don’t escape income tax. Your share of the S-corp’s profit is taxed on your personal return whether you take the cash or leave it in the business, which is why most S-corp owners also make quarterly estimated payments. If there are two or more owners, distributions generally have to follow ownership percentages, so pay any extra reward for extra work as salary, not as a lopsided distribution.
What to do this week
- Write down how your week actually splits across roles, in rough percentages.
- Pull market pay for each role from the BLS wage data for your state or metro area, and save the pages.
- Work out a salary range, pick a number inside it, and write a one-paragraph memo explaining how you got it. Keep it with your tax records.
- Check that payroll is actually running at that number, and that your health insurance will reach your W-2 by December.
- Compare year-to-date salary with distributions. If distributions are several times your salary and you work full time, fix it before December 31.
On our Bookkeeping & Tax plan, a CPA-backed team sets a salary you can defend, checks it against your books every month, and files your 1120-S and personal return. Payroll is a separate add-on. If you’d like a second opinion on your number first, book a free 15-minute call.