The tax savings from an S corporation election come from one mechanic: the owner takes part of the profit as salary, subject to payroll tax, and the rest as distributions, which are not. The IRS knows this, and it has a simple response. An owner who works in the business is an employee under Section 3121(d)(1) and must be paid reasonable compensation for that work before taking distributions. This article covers how the IRS decides what is reasonable, what happens when it disagrees with you, and how to document a salary so it holds up.
Where the rule comes from
There is no line in the statute that says what an owner must be paid. The requirement comes from Rev. Rul. 74-44, a line of court decisions, and the IRS's own guidance to examiners. The best-known case is Watson v. Commissioner, where an accountant paid himself a modest salary from a firm generating far more, took the rest as distributions, and lost. The court accepted that he could take distributions but found the salary too low for the work he did, and recharacterized part of the distributions as wages, with payroll taxes, interest, and penalties on top.
The factors the IRS uses
IRS Fact Sheet 2008-25 lists what an examiner looks at, and the items line up with common sense:
- Your training, experience, and licenses.
- Your duties and responsibilities, and how much time you put in.
- What the business pays non-owner employees doing similar work.
- What comparable businesses pay for the same role.
- The history of salary and distributions, and whether distributions stay large while salary stays flat.
- Whether there is a written compensation agreement and a formula behind it.
The examiner is asking what it would cost to hire someone to do what you do. If you are a dentist, a software engineer, or a contractor who also runs the office, the answer is what the market pays for those hours. Starting from the distribution you want and calling the remainder salary is the approach that loses.
What too low looks like in practice
The clearest audit trigger is a profitable S corporation with no W-2 wages to its owner at all. The next is a salary far below what the owner's own employees earn. Beyond those, examiners look at ratios: an owner taking a small fraction of profit as wages while the business depends entirely on that owner's labor is hard to defend. There is no safe harbor percentage. The 60/40 and 50/50 rules of thumb that circulate online are not in any IRS guidance and will not carry an audit.
Reasonable compensation is a facts test, so the same salary can be fine for one owner and indefensible for another. An owner who has stepped back to a few hours a week of oversight can justify a low salary. An owner who is the business cannot.
What happens if the IRS reclassifies
When distributions are recharacterized as wages, the corporation owes the employer and employee shares of Social Security and Medicare tax on the reclassified amount, plus failure-to-deposit and late filing penalties on the payroll returns that should have reported it, plus interest. Several years can be opened at once. The correction also ripples into other items: the qualified business income deduction under Section 199A depends on W-2 wages, retirement plan contributions are limited by compensation, and state payroll filings in New York and New Jersey have to be amended too.
How to document it
A defensible number is one you arrived at before the year started, by a method you can explain, and recorded somewhere.
Write down the job. List the roles you fill (production, management, sales, administration) and estimate hours in each. Most owners do several jobs at different market rates, and the blended figure is the compensation.
Price the roles. Use published wage data for your area, such as Bureau of Labor Statistics occupational wage tables, industry salary surveys, or a purchased compensation report. Keep the source with your tax file.
Put it in the minutes. A short board resolution setting the salary and the reasoning, adopted each year, is the single most useful document in an audit. Adjust the number when the facts change: a new hire who takes over half your work, or a year where you doubled your hours.
Run it through payroll. The salary should be paid through payroll on a regular schedule, reported on Forms 941 and W-2, and never booked as a year-end journal entry.