Understanding Reasonable Compensation for S-Corp Owners: IRS Guidelines Every Business Should Know
- Cherie Sayban
- 17 hours ago
- 3 min read
When you own an S-corporation (S-Corp), one of the most important—and scrutinized—decisions you’ll make is how to compensate yourself. The IRS has clear expectations: owners who provide services to their S-Corp must receive a reasonable salary before taking distributions. Understanding what “reasonable compensation” means and how the IRS evaluates it can help you avoid costly penalties and keep your business compliant.
In this article, we’ll break down what reasonable compensation means, how it’s determined, common pitfalls, and best practices to stay ahead.
What Is Reasonable Compensation?
Reasonable compensation refers to the salary an S-Corp owner must pay themselves for services rendered to the business—before taking the taxpayer-advantageous distributions. The IRS requires this to ensure owners don’t reduce payroll taxes by taking unreasonably low salaries.
S-Corp owners receive two types of income:
💵 W-2 wages (salary) subject to payroll taxes (Social Security and Medicare), and
💵 Distributions which are generally not subject to self-employment tax.
How the IRS Determines Reasonable Compensation
The IRS doesn’t provide a strict formula, but it offers guidelines and factors to evaluate whether compensation is reasonable.
Key Considerations
🔑 Role and Responsibilities
What duties did the owner perform? The level of involvement matters.
🔑 Training and Experience
An owner with specialized expertise may justify higher compensation.
🔑 Time and Effort Invested
Full-time involvement commands higher salaries than part-time participation.
🔑 Comparable Industry Salaries
Comparable salaries in similar businesses and locations are strong benchmarks.
🔑 Business Size and Complexity
A larger or more complex business typically supports higher compensation.
🔑 Economic Conditions
Industry trends and regional economic climates affect salary norms.
Why It Matters: IRS Scrutiny and Penalties
The IRS actively audits S-Corp owners to ensure compliance with reasonable compensation rules. If compensation is deemed too low, the IRS may reclassify distributions as wages, resulting in:
🔍 Back payroll taxes (Social Security and Medicare)
🔍 Interest and penalties
🔍 Unplanned tax liabilities
In other words, trying to minimize your salary could end up costing you more in the long run.
Best Practices for S-Corp Owners
📈 Use Industry Data
Use reputable salary surveys like:
Bureau of Labor Statistics (BLS)
Professional associations
Industry compensation reports
Document how your salary compares.
🧾 Document Your Decision
Maintain clear documentation supporting how your salary was determined. Include:
Job descriptions
Time logs
Industry salary data
Board or shareholder resolutions (if applicable)
This documentation is invaluable if your return is audited.
🗓️ Reevaluate Annually
Business needs and owner roles change. Review your compensation each year to ensure it aligns with current responsibilities and industry standards.
👩💼 Work with a Professional
A CPA experienced with S-Corp tax law can help you:
Set defensible compensation
Prepare payroll correctly
Avoid IRS challenges
Final Thoughts
Reasonable compensation for S-Corp owners isn’t optional—it’s a requirement. While tax savings from distributions can be tempting, paying yourself an appropriate salary protects you from IRS audits and penalties.
At Cherie Sayban, CPA, we’re here to help you navigate the complexities of S-Corp compensation and optimize your tax position with confidence and compliance. If you have questions about setting or documenting reasonable compensation, let’s talk!
About the Author
Cherie Sayban is a certified public accountant. She has over 25+ years of experience in Finance, Accounting and Bookkeeping.
Cherie Sayban CPA provides various financial and accounting solutions to small and mid-size businesses. Our portfolio includes: tax preparation, payroll preparation, accounts receivable and payables, general ledger, and QuickBooks . Our bookkeeping workshops are offered both in-person and virtually.
To learn more about how Cherie Sayban CPA can help you and your business, click HERE
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