A reasonable S-Corp salary is what the IRS requires you to pay yourself before taking distributions, and it needs to reflect what someone else would earn doing your actual job.
The number matters because salary gets taxed at 15.3% for payroll taxes, while distributions avoid that entirely. Of course, this creates an incentive to keep your salary as low as possible and maximize distributions. That's where the tax advantage lives, but it's also where most S-Corp owners get themselves into trouble.
The IRS has been watching business owners play this game for decades. Pay yourself too little in salary and take too much in distributions, and you're risking an audit that can result in reclassified income, penalties, and years of back taxes. Getting this right isn't optional.
So how do you maximize your tax savings without getting yourself in trouble? Read on, dear reader.
What Is a Reasonable Salary for an S-Corp Owner?
The IRS requires that S-Corp shareholders who perform significant services for the business pay themselves reasonable compensation. That means a salary comparable to what a similar business would pay someone else to perform the same work. Not a token salary. Not the lowest number your accountant will sign off on. What the market would actually pay for your role.
Once you've paid yourself a fair salary, you can distribute additional profits to yourself at a lower tax rate. That's the tax advantage, but it only works when you follow the IRS guidelines.
Why the IRS Cares So Much
S-Corp distributions avoid the 15.3% self-employment tax that applies to wages. Without reasonable compensation rules, S-Corp owners could pay themselves nothing in wages, take all profits as distributions, and avoid FICA taxes entirely.
The IRS is smarter than that. The government wants its taxes, so they're going to do what they have to in order to collect. They've been challenging low-salary S-Corp arrangements since a 1974 Revenue Ruling, and enforcement has only increased since then.
The real-world consequences are significant. If you're audited, the IRS can reclassify distributions as wages, resulting in massive back taxes, penalties, and interest. One case involved a CPA paying himself $24,000 in salary while taking $220,000 in distributions. The IRS reclassified $151,000 of those distributions as wages. That's a costly lesson in what “reasonable” actually means.
How the IRS Determines What's Reasonable
There's no official formula, which is both the good news and the frustrating news. The IRS examines several factors: the duties and responsibilities of the owner, industry standards, the owner's experience and qualifications, hours worked, and the overall revenue and profitability of the business.
The three most accepted approaches are:
- Market Approach – estimates your salary based on what similar roles earn in comparable companies
- Cost Approach – breaks down your duties into components and assigns comparable wages to each
- Income Approach – examines whether your salary level would satisfy a hypothetical outside investor.
How to Actually Calculate Your Reasonable Salary
The goal here isn't to find the lowest defensible number. It's to find a number you can document and explain if anyone ever asks. Here's a practical process for getting there.
Start with market data. Look up your role on the Bureau of Labor Statistics Occupational Outlook Handbook, Glassdoor, LinkedIn Salary, or PayScale. Search for your specific function, not just your industry. If you run operations, pricing, finance, and handle client work, you're wearing multiple hats, and your salary should reflect that. A general manager or operations director at a comparable company is often a reasonable benchmark.
Factor in your actual hours and responsibilities. An owner working 20 hours a week has a different compensation baseline than one working 60. Document what you actually do, even a simple written job description helps, and match that to market data for comparable roles and time commitments.
Consider your business revenue and profitability. If your S-Corp is generating $500,000 in net profit, a $30,000 salary is going to look thin regardless of what market data says. The IRS looks at whether the compensation makes sense in the context of the business's overall financial picture.
Get your accountant involved. This part isn't optional. A good CPA or tax advisor who works with S-Corps regularly will have a feel for what looks reasonable in your industry and income range, and they can help you land on a number with actual professional backing behind it. That documentation matters far more than the number itself if you're ever examined.
Review it annually. Your salary should move as your business grows. A number that was reasonable at $200,000 in revenue may not hold up at $800,000. Build a habit of revisiting it each year with your accountant, especially if your distributions have grown significantly.
What About the 60/40 Rule?
A commonly referenced strategy is to split revenue 60% as salary and 40% as distributions. The IRS does not endorse this guideline. The salary you arrive at using this rule is arbitrary and may not pass muster with the IRS. Use it as a rough sanity check if you want, but don't treat it as a compliance strategy. Market data and documented reasoning will always be a stronger defense than a ratio someone read on the internet.
2025 Numbers You Should Know
For 2025, the Social Security tax wage ceiling is $176,100. Both the S-Corp and the shareholder-employee each pay 6.2% Social Security tax on earned income up to that ceiling, plus 1.45% Medicare tax on all salary income.
Paying yourself at or above the Social Security wage base reduces audit risk for highly profitable businesses, because you've maximized Social Security contributions, making tax avoidance harder to argue. That said, it's not a guaranteed safe harbor for every role.
Document Everything
Whatever salary you set, write down how you got there. Services rendered throughout the year must be paid regularly. Lump-sum W-2 payments may raise red flags with the IRS. Consistent, documented, regular payroll is what compliance actually looks like in practice.
Keep a file with the market research you used, your job description, your hours, and the reasoning behind your number. If your accountant signed off on it, document that too. A well-kept paper trail is worth more than any specific dollar amount when the IRS comes asking questions.
This is also where payroll software earns its keep in a meaningful way. Running clean, consistent payroll with proper records removes a significant layer of audit risk and keeps your compensation history organized without you having to think about it.
The Bottom Line
Getting your S-Corp salary right isn't about gaming the system. It's about understanding what the IRS expects, doing the homework to support your number, and running payroll in a way that holds up to scrutiny. The tax savings are real, but they only work when the foundation is solid.
I've been using Gusto for years and it's kept me sane through all of it. For S-Corp owners especially, having payroll run correctly, on schedule, with clean records isn't a nice-to-have. It's the whole point. Gusto handles the salary side seamlessly, whether you're a solo S-Corp owner or managing a larger organization with more complex payroll needs. If you're still running S-Corp payroll manually, that's a risk that's genuinely not worth taking.
This article is for informational purposes only and does not constitute legal or tax advice. Please consult a qualified CPA or tax professional regarding your specific situation.
