S-Corp Reasonable Compensation: Setting a Defensible Salary

The Core Trade-Off

An S-Corp owner who also works in the business must pay themselves a reasonable salary — wages subject to FICA (Social Security and Medicare, 15.3% combined up to the Social Security wage base). Any remaining profit can be taken as a distribution, which is not subject to payroll tax. The gap between what you pay as salary and what you take as distribution is where the savings live.

What "Reasonable" Actually Means

The IRS does not publish a fixed dollar figure for reasonable compensation. It is a facts-and-circumstances standard, and examiners weigh several factors:

• Training and experience — your professional qualifications relative to the role you fill.
• Duties and responsibilities — what you actually do day to day, not just your title.
• Comparable compensation — what similarly situated employees in your industry and region earn for comparable work.
• Time and effort — hours devoted to the business.
• Distributions vs. salary history — a pattern of low salary and high distributions draws scrutiny.
• Prevailing rates in similar businesses — industry salary surveys and benchmarking data.

A Practical Framework

1. 1
   Benchmark the role, not the person.

   Identify the specific functions you perform (operations, sales, delivery) and find market data for each. Blend the rates by time allocation.
2. 2
   Document your analysis in writing.

   Keep a contemporaneous compensation memo each year citing the data sources, comparable roles, and your reasoning. The memo is your defense.
3. 3
   Run payroll — don't skip it.

   Pay the salary through a real payroll system with withholdings, W-2, and timely deposits. Zero salary with large distributions is the #1 audit trigger.
4. 4
   Review mid-year.

   Profits and roles change. A mid-year salary review lets you adjust before December 31 instead of after the fact.
5. 5
   Keep the ratio defensible.

   There's no bright-line rule, but salary should reflect the services you provide. Aggressively low salaries relative to profit are what get reclassified.

The Bottom Line

Reasonable compensation isn't about finding the lowest defensible number — it's about finding the number you can defend with a straight face and a written analysis. The owners who save the most over time are the ones who set a defensible salary, document it, and revisit it as the business grows.