Reasonable Compensation: How the IRS decides what your salary should be
If you own an S-corporation, you’ve probably heard that you need to pay yourself a “reasonable salary.” It sounds simple — until you try to figure out what number that actually is. Set it too high and you hand over payroll tax you didn’t need to pay. Set it too low and you’ve walked into the single most common reason the IRS audits S-corporations. Getting this number right is where the tax savings of an S-corp are either protected or lost.
Here’s what reasonable compensation means, why it matters so much, and how the number is actually determined.
Why the salary number matters so much
The entire tax advantage of an S-corp comes from splitting your income into salary (subject to payroll tax) and distributions (not subject to payroll tax). Because distributions escape the 15.3% self-employment/payroll tax, there’s a built-in temptation to make the salary as small as possible and take everything else as distributions.
The IRS knows this — and it’s exactly what they look for. If they decide your salary was unreasonably low, they can reclassify your distributions as wages, then assess the back payroll taxes you avoided, plus penalties and interest. The savings you thought you locked in get clawed back, with extra cost on top. A defensible salary is what keeps the strategy legitimate.
There’s no single IRS formula or magic percentage for reasonable compensation. Anyone who tells you “just pay yourself 50% of profit” is oversimplifying — the right number depends on facts specific to you and your role.
What “reasonable” actually means
The standard the IRS applies is what you would have to pay someone else to do the work you do for the business — fair market value for your labor. In other words: if you walked away and had to hire a replacement to perform your role, what would that person earn? That’s the anchor.
Courts and the IRS weigh a number of factors when judging whether a salary meets that standard:
Your role and duties. What you actually do — and how much of it is skilled, revenue-generating work versus passive ownership.
Training and experience. Your qualifications, credentials, and years in the field.
Time devoted to the business. Full-time, part-time, or minimal involvement.
Comparable salaries. What similar businesses pay for similar work in your area and industry.
What the business can support. Your revenue and profitability, and how much of the profit is attributable to your work versus capital or other employees.
How you pay non-owner employees. Consistency between your compensation approach and how you treat staff.
How the number is determined in practice
Because there’s no formula, a defensible salary is built from evidence rather than a guess. In practice that means:
Define the role honestly. Break down what you do and roughly how your time splits across functions — a single-owner business often wears many hats (the work of a manager, a technician, a salesperson), each with its own market rate.
Find real market data. Use compensation surveys, Bureau of Labor Statistics wage data, and industry sources to establish what each role pays. This is the evidence that backs the number.
Blend to a defensible figure. Combine the role rates, weighted by time, into a salary that reflects the fair market value of everything you do.
Document it. Keep the analysis on file. If you’re ever questioned, contemporaneous documentation of how you arrived at the number is your best defense.
The goal isn’t the lowest number you can get away with — it’s the lowest number you can defend with evidence. Those are very different things, and the gap between them is exactly where audit risk lives.
Four common mistakes that draw scrutiny
A $0 or token salary while taking large distributions. The clearest red flag there is, especially in a profitable single-owner business.
Picking a round percentage with no basis. “40% of profit” might happen to be reasonable — or might not. Without supporting evidence, it’s just a guess.
Never revisiting the number. As your business and role change, so should the analysis. A salary set once and forgotten can drift out of line.
Ignoring it in a loss year. Reasonable comp interacts with distributions and basis in ways that matter even when profits are thin; it deserves attention every year.
The bottom line
Reasonable compensation is the guardrail that makes the S-corp tax strategy work. Done well — a defensible salary backed by real market evidence and documented — it lets you capture the legitimate payroll-tax savings of an S-corp while staying off the IRS’s radar. Done poorly, it turns the savings into a liability. It’s not a number to pull from thin air or copy from a forum; it’s a small piece of analysis that protects a large piece of strategy.
Not sure your salary would hold up? Reasonable-compensation analysis is one of the core services I provide for S-corp owners — a defensible figure, backed by real data and documented for your files. Accord Tax & Planning offers a free 30-minute consultation by video, wherever you are.
Schedule your free consultation.
This article is general information, not tax advice for your specific situation. Tax outcomes depend on your individual facts; please consult a qualified tax professional before acting. Accord Tax & Planning · Enrolled Agent, federally licensed to represent taxpayers before the IRS.