How to Determine a Reasonable Shareholder Salary

A shareholder salary is the compensation an owner receives for the work they perform for their own business. This topic is most significant for owners of S corporations, though it also has relevance for C corporations. When an owner is actively involved in the company’s operations, they are considered an employee, and the payment they receive for these services is treated as wages under Internal Revenue Service (IRS) rules.

The structure of an S corporation allows profits to pass through to the owners’ personal tax returns. This necessitates a clear distinction between money paid as a salary for services and money paid as a distribution of company profits. Understanding this distinction is important for any owner-employee, as the IRS closely scrutinizes these payments to prevent the mischaracterization of income.

The Reasonable Compensation Requirement

The IRS mandates that S corporation shareholders who provide services to their business must be paid “reasonable compensation.” The purpose of this requirement is to prevent the avoidance of payroll taxes. Employee wages are subject to Social Security and Medicare taxes (FICA) and federal unemployment (FUTA) taxes. The FUTA tax is levied on the first $7,000 of an employee’s wages.

Distributions of profit from an S corporation, unlike salaries, are not subject to these payroll taxes. This creates a tax incentive for a shareholder to minimize their salary and take more of their income as a distribution. Wages are subject to a FICA tax of 15.3%, which is split between the employee and the employer. The corporation pays 7.65% and the employee pays 7.65% through payroll withholding.

The FICA tax consists of two parts: a 12.4% Social Security tax that applies to wages up to an annual limit, which is $176,100 for 2025, and a 2.9% Medicare tax that applies to all wages. High-earning employees also pay an additional 0.9% Medicare tax on wages over certain thresholds, which is not matched by the employer.

The IRS has the authority to reclassify payments if it determines a salary is unreasonably low. If an owner pays themselves a token salary while taking large distributions, the IRS can challenge this arrangement. In an audit, the agency could recharacterize a portion of the distributions as wages, resulting in back payroll taxes, penalties, and interest.

The concept of “reasonable” is not defined by a specific dollar amount or formula in the tax code. Instead, it is based on the facts and circumstances of each case. The IRS and courts look at what similar enterprises would pay for the same or similar services under like circumstances.

Methods for Determining a Reasonable Salary

There is no single formula for calculating a reasonable salary; instead, the IRS and courts rely on a multi-factor analysis to determine if compensation is appropriate. This approach requires a business owner to conduct an objective assessment of their role and contributions.

Employee’s Qualifications

A shareholder’s background, including their experience, training, and education, is a factor. An owner with advanced degrees, specialized certifications, and decades of industry experience can justify a higher salary than an owner with limited experience or formal training. The analysis should consider what it would cost to hire a non-owner with a similar set of qualifications to perform the same job.

Nature of the Work Performed

This factor examines the specific duties and responsibilities the shareholder performs. Are they a high-level executive making strategic decisions, a manager overseeing daily operations, or a technician providing specialized services? The complexity and scope of the work are directly related to its value. A detailed job description should be created for the shareholder-employee, outlining all their functions within the business.

Time and Effort Devoted to the Business

The amount of time a shareholder dedicates to the business is a consideration. An owner working 60 hours per week managing all aspects of the company would command a higher salary than a shareholder who works part-time or has a more limited, advisory role. It is useful to maintain records or logs that provide a reasonable estimate of the hours worked and the activities performed during that time.

Compensation Paid for Similar Positions in Comparable Companies

This is one of the most persuasive factors in determining a reasonable salary. The analysis involves researching what other companies of a similar size, in the same industry and geographic location, pay their employees for comparable roles. Reputable sources for this data include the U.S. Bureau of Labor Statistics, private salary survey companies, and industry trade associations. Obtaining a formal compensation analysis report from a specialized firm can also provide strong evidence.

Company’s Size and Complexity

The size of the business, measured by metrics like gross revenue, total assets, and number of employees, influences the level of responsibility and compensation for its leadership. Managing a large, complex organization with multiple locations warrants a higher salary than running a small, simple operation. The company’s financial performance and overall profitability are also taken into account.

General Economic Conditions

External economic factors can play a role in justifying a compensation level. During a period of strong economic growth within a specific industry, higher salaries may be the norm. Conversely, during an economic downturn or a period of financial struggle for the business, a lower salary might be deemed reasonable.

Salary vs. Distributions in an S Corporation

For an owner who works in their S corporation, money can be taken out of the business in two ways: as a salary and as a distribution. IRS rules state that reasonable compensation must be paid before distributions are made to a shareholder-employee.

A salary is a payment for services rendered and is treated as a business expense for the corporation, which reduces the company’s net profit. The salary paid to a shareholder-employee is subject to payroll taxes. The business pays the employer’s share of these taxes, and the employee’s share is withheld from their paycheck, along with income taxes. At the end of the year, the shareholder receives a Form W-2 detailing their wages and withholdings.

Distributions are paid out of the company’s net profits that remain after all expenses, including the shareholder’s salary, have been paid. These payments are not a business expense and are not subject to payroll taxes. Instead, they represent a return on the shareholder’s investment in the company. The shareholder’s portion of the company’s total profit is reported to them on a Schedule K-1.

For example, an S corporation has a net profit of $150,000 before accounting for the owner’s salary. A reasonable salary for the owner is determined to be $60,000. The corporation would pay this $60,000 as wages, withholding the employee’s share of FICA and income taxes. The corporation would also pay its own share of FICA and FUTA taxes on that salary. This $60,000 salary is a deductible expense, which reduces the company’s remaining profit to $90,000. This remaining amount can then be paid to the owner as a distribution.

Implementing and Documenting Shareholder Compensation

Once a reasonable salary has been determined, the next step is to properly implement the payment and document the decision-making process. The salary must be paid through a formal payroll system, treating the shareholder-employee just like any other employee of the company.

The business must withhold the appropriate amounts for federal income tax, state income tax where applicable, and the employee’s share of Social Security and Medicare taxes. The corporation is also responsible for making its matching employer contributions for payroll taxes and remitting these funds to the IRS on a timely basis, typically quarterly using Form 941. At the end of the year, the corporation must issue a Form W-2 to the shareholder-employee that accurately reflects the wages paid and taxes withheld.

A clear paper trail to justify the salary amount is a defensive measure. This documentation should be formally adopted and recorded in the corporate records, such as in the minutes of a board of directors’ meeting. The meeting minutes should state the approved salary and provide a summary of the analysis that was conducted to arrive at that figure.

This summary should reference the specific factors considered, such as the employee’s duties, experience, and the comparable salary data that was used. Keeping copies of the salary surveys, job descriptions, and financial reports used in the analysis provides tangible evidence that the decision was methodical and not arbitrary.