S Corporation Reasonable Compensation, Explained

If you own an S corporation and work in the business, the IRS expects you to be paid wages for that work before you take distributions of profit. The wages have to be reasonable.

Why the rule exists

Wages are subject to payroll taxes (Social Security and Medicare). Distributions from an S corporation are not. Without a rule, an owner could pay themselves a very small salary and take almost everything as a distribution to avoid payroll tax. The reasonable compensation rule stops that.

What "reasonable" means

There is no single formula. The question is what the business would have to pay someone else to do the work you do. Factors that are commonly considered include:

• Your duties and how much time you spend in the business
• Your training and experience
• What similar businesses pay for similar work
• The size and profit of the business
• What you take out of the business in total

What it looks like in practice

An owner who runs the business day to day, bills clients and manages staff is doing more than one job. The salary should reflect that. An owner who is a passive investor and does not work in the business may not need a salary at all.

What can go wrong

• Paying no salary at all and taking only distributions
• Paying a salary far below what the work is worth
• Not running payroll properly, so withholding and payroll tax filings are missing
• Changing the salary each year with no records of how it was chosen

The IRS can reclassify distributions as wages in an examination, which can mean back payroll taxes, interest and penalties.

How to approach it

Write down how you arrived at the salary. Look at what similar roles pay, set the salary through payroll, and review it when your role or the profit of the business changes. A tax professional can help you document the figure and run the payroll correctly.

This is general information. What is reasonable depends on your facts.