The S-corp savings come from paying yourself part salary, part distribution. Pay yourself too little salary and the IRS notices — here’s how to find the line.
An S-corporation’s tax advantage hinges on a split: the salary you pay yourself is subject to payroll tax, and the distributions you take are not. Naturally, owners are tempted to make the salary tiny. The IRS knows this, and “reasonable compensation” is exactly where they look.
What “reasonable” means
The standard is simple to state: you must pay yourself what you’d have to pay someone else to do your job. Set the salary too low to dodge payroll tax and you risk having distributions reclassified as wages — with back taxes and penalties attached.
How to actually set it
- Market rate for your role. What does someone with your skills, in your industry and region, earn? Salary surveys and job listings are real evidence.
- Your hours and duties. A full-time owner running everything justifies more than a passive one.
- What the business can support. Salary should bear a sensible relationship to profit — a token wage on large profits is the classic red flag.
Many advisors look at a salary that’s a defensible share of net profit — enough to look like genuine market pay for the work, leaving the rest as distribution. The exact split depends on your role and numbers, and it’s worth documenting how you arrived at it.
Document the decision
The number matters less than being able to show how you reached it. Keep the salary data you relied on, note your hours and responsibilities, and revisit it as the business grows. If the figure is ever questioned, that file is your defense.
Get this right and the S-corp election does exactly what it’s supposed to — real savings, cleanly defensible. We help clients set the number, run the payroll, and keep the support on file so it holds up.