What Is Reasonable Compensation for an S Corp Owner?

By Kendall Maccagnan, CPA, CFP® and Financial Advisor in Tampa, Florida

Reasonable compensation for an S corp owner is the salary the business would pay someone else to do the work you do. The IRS doesn't set a percentage or dollar amount; it depends on your duties, time, experience, and what comparable roles pay in your market.

If you own an S corporation and work in the business, you have probably heard that you need to pay yourself a “reasonable salary.” But what exactly does reasonable mean?

Unfortunately, the IRS does not give S Corp owners a magic percentage or salary number to use. Reasonable compensation generally depends on the work you perform, how much time you spend in the business, your experience and responsibilities, what comparable positions pay, and other facts specific to your company.

That means paying yourself $30,000 just because another business owner told you that is what they pay themselves is probably not the best strategy. Let’s talk about how reasonable compensation actually works.

Key Takeaways

• The IRS doesn't set a percentage or dollar amount for S corp owner salaries. Reasonable compensation depends on your role, time, experience, and what similar work pays.

• Rules of thumb like a 60/40 salary/distribution split are not a substitute for looking at what you actually do in the business.

• A practical starting point is to estimate what it would cost to hire someone to do your jobs, then document how you got to your number.

• Paying yourself too little may lead the IRS to reclassify distributions as wages, which can mean owing back payroll taxes, penalties, and interest.

What Is Reasonable Compensation for an S Corp Owner?

One of the potential tax benefits of an S corp election is the ability to receive money from your business through both W-2 wages and shareholder distributions.

Those two buckets are treated differently for employment tax purposes.

W-2 wages are generally subject to Social Security and Medicare taxes. S Corp distributions generally are not subject to those same employment taxes. For Florida business owners, there's one more piece. Florida doesn't have a state income tax, but S corp wages are generally subject to Florida reemployment tax, which the business pays on the first $7,000 of each employee's wages per year, including yours.

If business owners could just pay themselves $1 of salary and take everything else as distributions, everyone would do it! Unfortunatley, the IRS may not like that.

That is where the reasonable compensation requirement comes in.

If you are an S corporation shareholder-employee providing services to the business, the IRS generally requires the corporation to pay you reasonable compensation for those services before making non-wage distributions to you.

The question then is: What is a reasonable salary?

There Is No IRS Reasonable Compensation Percentage

There is no universal IRS-approved percentage for determining reasonable compensation.

You may have heard rules of thumb suggesting that 50%, 60%, or some other percentage of your business income should be salary and the remainder can be distributions. Reasonable compensation is actually based on the facts and circumstances of your particular business, not rule of thumb percentages.

As an example, consider two S Corp owners whose businesses each generate $200,000.

One is a consultant with no employees. Almost all of the company's revenue comes directly from the owner's knowledge and work.

The other owns a plumbing company with several technicians generating revenue in the field while the owner spends 20 hours per week managing the team.

Their businesses may generate the same income, but the owner's role in generating that income is completely different so therefore their reasonable compensation will likely be different.

	Owner A	Owner B
Business profit	$200,000	$200,000
Salary	$80,000	$20,000
Distributions	$120,000	$180,000

What Does the IRS Look at for S Corp Reasonable Compensation?

When evaluating reasonable compensation, the IRS points to several factors that may be relevant, including:

• Your training and experience

• Your duties and responsibilities

• The time and effort you devote to the business

• The company's dividend history

• Payments made to non-shareholder employees

• How and when bonuses are paid to key employees

• What comparable businesses pay for similar services

• Compensation agreements

• Whether a formula is used to determine compensation

  
  

One useful question to ask yourself may be: Where does the company's revenue actually come from?

If most of the revenue is generated directly from your personal services, your role may support a different compensation analysis than a business where employees, equipment, or other assets generate a significant portion of the revenue.

This is why reasonable compensation for a solo consultant may look very different from reasonable compensation for the owner of a larger HVAC, plumbing, electrical, or other service business with multiple employees.

How Can You Determine a Reasonable S Corp Salary?

I like to start by temporarily forgetting that you own the business. Imagine you decided tomorrow that you were done working and needed to hire someone to replace you. What jobs would that person actually need to perform?

Maybe you spend:

• 40% of your time delivering services to customers

• 25% managing employees

• 15% on sales

• 10% handling administrative work

• 10% on bookkeeping and finances

Now ask yourself what you would reasonably need to pay someone in your market to perform those responsibilities. You may actually need more than one person to replace you!

That exercise can give you a defensible starting point. Comparable salary information for similar positions may also help support the analysis. The goal is to connect your compensation to the services you actually perform for the business and document how you arrived at your number.

Why Paying Yourself Too Little Can Be a Problem

It can be tempting to minimize your W-2 salary because distributions generally are not subject to Social Security and Medicare taxes. Taking a very small salary while receiving significant distributions can create a problem if the compensation does not reasonably reflect the services you provide.

The IRS can reclassify certain payments or distributions as wages if it determines they were actually compensation for services. Depending on the circumstances, this may result in additional employment taxes, penalties and interest.

What Happens if You Take Distributions Without a Salary?

What if you made an S Corp election, spent the year taking distributions from the business, and then realized you completely forgot to put yourself on payroll?

How you fix the problem depends on when you catch it.

If you realize the mistake during the same calendar year, there may still be an opportunity to determine an appropriate amount of compensation, run payroll, make the required payroll tax deposits, and file the appropriate payroll forms.

If you discover the issue after the year has already ended, the correction can become more complicated. Depending on what was previously filed, correcting the issue may involve amended payroll tax returns, corrected wage reporting, additional employment taxes, and potentially penalties or interest.

Revisiting Your Salary as Your Business Grows?

When determining reasonable salary for your S Corp, a good place to start may be with your actual role in the company: what you do, how many hours you work, how much experience you have, where the revenue comes from, and what someone performing similar work might reasonably earn.

For Tampa Bay and Florida business owners, compensation planning can also be considered alongside the rest of the financial picture. Your salary may affect payroll taxes, business cash flow, retirement planning, personal spending, and how much money ultimately moves from the business to your personal balance sheet.

Reasonable compensation should therefore be more than a number you pick once and forget about. As your company grows and your role changes, it may make sense to revisit whether your compensation still reflects what you actually do.

If you want help evaluating your S Corp compensation alongside your business cash flow, taxes, and personal financial plan, feel free to book a consultation to discuss financial planning and tax planning for business owners.

Frequently Asked Questions About S Corp Reasonable Compensation

What is reasonable compensation for an S Corp owner?

Reasonable compensation is the amount an S corporation pays a shareholder-employee for services performed for the business. There is no universal dollar amount or percentage. The appropriate salary generally depends on factors such as the owner's duties, experience, time spent working in the business, responsibilities, and comparable compensation for similar work.

Is there an IRS reasonable compensation percentage for S Corps?

No. The IRS does not provide a universal reasonable compensation percentage or require S Corp owners to use a specific salary to distribution ratio. Rules of thumb such as a 60/40 split should not replace an analysis of the facts and circumstances of the business and the services the shareholder-employee actually performs.

Can an S Corp owner take distributions without a salary?

An S corporation shareholder who performs more than minor services for the corporation and receives or is entitled to receive payment generally cannot simply characterize all compensation as distributions. Shareholder-employees who provide services generally need to receive reasonable compensation as wages before receiving non-wage distributions.

How do I calculate reasonable compensation for an S Corp owner?

Start by identifying the actual jobs you perform for the company, the amount of time spent on each responsibility, your experience and training, and what comparable businesses pay for similar services. It may be helpful to think about what the company would have to pay someone else to perform the work you currently perform and document how you arrived at your compensation amount.

What Happens If an S Corp Owner Takes Distributions but No Salary?

 If an S corp owner works in the business and takes distributions without a reasonable salary, the IRS can reclassify some or all of those distributions as wages. That can mean back payroll taxes, plus penalties and interest for payroll filings that were never made. The usual fix is to start running payroll right away and work with a CPA to correct prior periods where needed. Setting a reasonable salary going forward helps avoid the issue entirely.

This content is provided for educational and informational purposes only and should not be construed as investment, tax, or legal advice. It is not intended as a solicitation or offer to provide advisory services in any jurisdiction where Off the Bay Wealth, LLC is not properly registered or otherwise permitted to operate. Information presented is based on sources believed to be reliable; however, accuracy and completeness are not guaranteed. This material is not intended to be a comprehensive analysis of all topics discussed. IRS provisions are subject to ongoing guidance and regulatory updates. Any financial decisions should be made in consideration of your individual circumstances, including your goals, risk tolerance, and time horizon. Investing involves risk, including the potential loss of principal.