Every S-corp owner eventually runs into the same question from their accountant: what should your salary actually be. It sounds like a simple number to pick, but it’s one of the few areas where the IRS actively looks for businesses getting it wrong, and getting it wrong can unwind the whole reason an S-corp made sense in the first place. Lang Tax Solutions works through this calculation with clients every tax season, and the short version is that reasonable compensation isn’t a guess or a round number, it’s a defensible figure tied to what the work is actually worth.
Why this matters more than owners expect
The appeal of an S-corp is straightforward. Profit distributed to the owner beyond salary isn’t subject to self-employment tax, which is a real savings compared to a sole proprietorship or single-member LLC. But the IRS knows this incentive exists, and the rule is simple even if applying it isn’t: an owner who works in the business has to be paid a reasonable salary for that work before any profit gets distributed. Pay yourself too little and take the rest as distributions, and the IRS can reclassify those distributions as wages, hit you with back payroll taxes, and add penalties and interest on top.
This isn’t a rare enforcement action either. Reasonable compensation is one of the more commonly audited issues for S-corps specifically because it’s an easy pattern to spot. A business with $200,000 in profit and an owner salary of $20,000 stands out immediately.
What “reasonable” actually means
There’s no single formula the IRS publishes, but court cases and IRS guidance point to the same handful of factors. What would it cost to hire someone else to do this owner’s actual job, given their training, experience, and time commitment. What do similar roles pay in the same industry and region. How much of the owner’s time goes into the business, and what functions do they perform, sales, operations, management, technical work.
A useful way to think about it: separate the owner into two people on paper. One person does the actual job, managing the shop, doing the technical work, running sales calls. The other person owns the business and earns a return on that ownership. The first person gets a salary. The second person can receive distributions. The salary has to reflect what the first person’s job would cost to replace.
Using comparable salary data
Salary survey data is the most defensible starting point. Sources like the Bureau of Labor Statistics wage data, RCReports, or industry-specific salary surveys give a documented range for a given role and region. An owner who also manages the company can reasonably blend two roles, say, a general manager salary plus a portion of a sales role, if that reflects how their time is actually split.
Common mistakes owners make
A lot of owners set salary based on what feels affordable rather than what the job is worth. In a slow year, salary gets cut to preserve distributions, which is exactly backwards from how the IRS views the requirement. Others set a number once at formation and never revisit it as the business grows, so a salary that made sense at $150,000 in revenue is clearly too low once the business is doing $600,000.
Another mistake is paying a flat number without any documentation explaining how it was determined. If the IRS ever asks, “that’s what we’ve always done” isn’t an answer. A short memo referencing comparable wage data, the owner’s actual duties, and hours worked is inexpensive insurance against a much more expensive problem later.
Setting it up correctly
Salary should run through payroll, with the usual withholding and employer payroll tax obligations, not as an owner draw relabeled at year end. It should be reviewed annually, especially after a meaningful change in revenue, role, or time commitment. And it should be set before distributions are taken for the year, not backfilled afterward to make the math work.
Getting this number right protects the tax savings an S-corp is supposed to provide instead of turning them into a liability waiting to surface at audit. If salary and distributions haven’t been reviewed together in a while, or the number was picked without any real benchmarking behind it, that’s worth fixing before it becomes an IRS letter instead of a planning conversation. Lang Tax Solutions helps S-corp owners across Sioux Falls and Omaha set compensation that holds up to scrutiny and still makes sense for the business.
