S Corp Reasonable Salary: How Much Should You Pay Yourself?

An S corporation election is one of the most effective tax moves for a profitable small business, but only if the owner's salary is set correctly. Set it too low and you invite an IRS challenge. Set it too high and you give back the savings that made the election worthwhile. Here's how to find the right number.

Why salary matters in an S corp

In a sole proprietorship or single-member LLC, all of your profit is subject to self-employment tax. An S corporation splits that profit into two pieces:

• W-2 salary, which is subject to payroll taxes (Social Security and Medicare), and
• Distributions, which are not.

That split is where the savings come from. But the IRS requires that an S corp owner who works in the business be paid reasonable compensation before taking distributions. Paying yourself $10,000 and taking $200,000 as distributions is exactly the pattern the IRS looks for.

What "reasonable" means to the IRS

There's no fixed percentage or formula in the tax code. "Reasonable" means what the business would have to pay someone else to do the work you do. In its guidance on S corporation compensation, the IRS points to factors like:

• your training and experience
• your duties and responsibilities
• the time and effort you devote to the business
• what comparable businesses pay for similar services
• the company's gross receipts and profitability
• your history of salary and distributions
• any formula or agreement the company uses to set pay

You may have heard of a "60/40 rule" (60% salary, 40% distributions). It isn't an IRS rule. It's a rule of thumb, and it can be wrong in both directions.

What happens if the salary is too low

If the IRS concludes your salary was unreasonably low, it can reclassify distributions as wages. That means back payroll taxes, plus penalties and interest. Courts have backed the IRS on this repeatedly. In David E. Watson, P.C. v. United States, a CPA who paid himself $24,000 while his firm distributed far more saw a large part of those distributions reclassified as wages.

What happens if the salary is too high

Overpaying yourself is safer, but it isn't free:

• Every extra dollar of salary carries payroll tax, which shrinks the savings the S corp was meant to create.
• Salary also reduces the business income that counts toward the Section 199A (QBI) deduction, though W-2 wages can help you qualify for that deduction at higher incomes. It's a balance worth modeling.

How we set a reasonable salary

At Blueprint Tax, we start from what the job is worth, not from the tax result we want:

1. Define the roles you actually fill. An electrician who also runs estimating and the books, or a physician who also manages a practice, is doing several jobs. We look at what each would cost to hire.
2. Benchmark against market pay. We use wage data for comparable roles in your area and industry, adjusted for the hours you actually work.
3. Run the numbers. We model payroll taxes, the QBI deduction, and retirement contributions (which for S corp owners are generally based on W-2 salary) at a few salary levels, so you can see the trade-offs.
4. Document the decision. A short memo on how the salary was determined is your best defense if the IRS ever asks.
5. Revisit it every year. As profit, duties, and hours change, the reasonable number changes too.

A few practical points

• Run real payroll. Salary must go through payroll with withholding and quarterly filings, not as occasional owner draws. In Texas, that also means registering with the Texas Workforce Commission.
• Health insurance counts. For owners with more than 2% of the company, S corp-paid health insurance is generally added to W-2 wages. It needs to be reported correctly to stay deductible.
• Take salary throughout the year. One payroll in December paired with distributions all year is a red flag.
• Retirement plans depend on salary. If you want to maximize a solo 401(k) or other owner retirement plan, your salary level directly affects how much you can contribute.

Is an S corp right for you?

An S corp election usually starts to pay off once profit is high enough that the self-employment tax saved on distributions outweighs the cost of running payroll and filing a separate return. We'll calculate that break-even point for your business and, if it makes sense, set up the salary, payroll, and quarterly estimates the right way.

Learn more about our business tax and S corp planning, or see how this fits into year-round tax planning.

This article is general information, not tax advice for your situation. Talk with a CPA before changing your compensation or entity structure.