The rule, stated plainly
An S corporation shareholder-employee who performs services must generally receive reasonable compensation for those services before non-wage distributions are made. 'Reasonable' means roughly what you'd have to pay someone else to do the work you actually do. There is no statutory number, no official safe-harbor percentage, and no magic formula; there is a facts-and-circumstances standard, enforced through audits, with decades of case law behind it.
What happens if you lowball it: the IRS can reclassify your distributions as wages, which triggers back payroll taxes on both the employer and employee side, plus penalties and interest, retroactively, for multiple years. The savings you 'captured' come back with a surcharge. Owners who take zero salary while pulling six-figure distributions aren't playing the odds; they're volunteering.
The myths to clear out first
- 'The 60/40 rule', the internet's favorite: 60% salary, 40% distributions. It appears nowhere in law or IRS guidance. A ratio that ignores what your work is worth is exactly the kind of arbitrary number that fails an exam. Useful only as a sanity check, never as a method.
- 'Just pay yourself the FICA max', the Social Security wage base is a tax threshold, not a salary benchmark. For some owners it's too much; for high earners it can still be too little.
- 'Distributions are optional, so salary can wait', if you're taking money out and working in the business, compensation comes first. The IRS has litigated the 'it was all distributions' position many times and essentially always wins.
How to actually build the number
Step 1: Define what you really do
An owner of a plumbing company is rarely just a plumber, she's part estimator, part sales manager, part dispatcher, part bookkeeper-wrangler. List the roles and roughly how your hours split across them. This matters because the defensible salary reflects the blend: master-plumber hours price differently than admin hours.
Step 2: Price the roles with real market data
Use sources you can print and file: BLS occupational wage data for your metro, industry salary surveys, job postings for comparable roles, or a reasonable-compensation report from services built for exactly this (RCReports and similar). The question each source answers: what would it cost to hire your replacement, role by role, at your hours?
Step 3: Adjust for the facts that matter
Courts and the IRS weigh: your experience and credentials, time actually worked (a 15-hour-a-week owner defensibly earns less than a 60-hour one), the company's revenue and profitability, what comparable businesses pay similar roles, and whether the business's success comes from your labor or from capital and staff. A salary below every comparable, in a business whose profit is clearly generated by your personal work, is the pattern that fails.
Step 4: Document it and revisit annually
Write the analysis down, roles, sources, number, date, and keep it with your corporate records. An owner who shows up to an exam with a documented methodology is in a completely different conversation than one who shrugs. Revisit when profit jumps, your role changes, or you cut your hours; a salary set in 2022 doesn't defend 2026.
A worked example
An HVAC company owner: profit around $180K before owner pay. Her week splits roughly half field/technical work, a quarter sales and estimating, a quarter management and admin. Metro wage data prices those roles blended at about $38–45/hour for her ~50-hour weeks, call it $95K–$110K as the replacement cost. She sets salary at $100K, documents the sources, and takes the remaining ~$80K as distributions. Payroll tax applies to the $100K; the $80K escapes self-employment tax, roughly $11–12K a year in savings, on a number built to survive scrutiny. That's the whole game: capture the real savings, skip the fictional ones.
The mechanics people forget
- Reasonable salary requires actual payroll: registrations, withholding, quarterly 941s, a W-2 in January, not a year-end journal entry. Payroll Administration for Small Businesses
- Salary timing is flexible; many owners run a modest monthly base plus a true-up in Q4 when the year's profit is visible.
- Retirement leverage: salary is what drives Solo 401(k) and SEP contribution limits, another reason artificially low salaries backfire on high savers.
- Health insurance for 2%+ shareholders runs through the W-2 under specific rules; get it on the payroll setup, not fixed retroactively.
Frequently asked questions
What if the business had a bad year?
Reasonable compensation scales with reality, a year with little profit and reduced owner hours supports a lower salary, and a genuinely unprofitable year may support none. The standard isn't a fixed number; it's honesty with documentation.
Is there a salary so low it's automatically fine?
No, and the inverse question is the better one: is the salary explainable? $40K for a part-time owner of a modest operation may be perfectly defensible; $40K under $400K of distributions in a business that is you, is not.
Who should actually run this analysis?
The firm that sees your real numbers all year. We set and revisit reasonable comp for our bookkeeping clients as part of tax work, with the payroll to implement it, since we run that too. Business Tax Preparation Services
Primary sources