Reasonable Compensation Guidelines for an S Corp

An S corporation allows income, losses, deductions, and credits to pass through to shareholders for reporting on their personal tax returns. A compliance issue for these businesses is the concept of “reasonable compensation.” Shareholder-employees must be paid a formal salary for their labor that the Internal Revenue Service (IRS) considers reasonable before taking any remaining profits as a distribution. The distinction between salary and distributions is important because they are taxed differently, placing this compensation decision under careful scrutiny.

Understanding the Salary vs. Distribution Distinction

The IRS closely examines S corporation compensation due to the different tax treatments for salaries and distributions. When an owner receives a salary, those wages are subject to federal and state income tax withholding and payroll taxes. These payroll taxes, governed by the Federal Insurance Contributions Act (FICA), fund Social Security and Medicare and are paid by both the employee and the employer.

For 2025, the Social Security tax rate is 6.2% for both the employer and the employee on wages up to the annual limit of $176,100, while the Medicare tax is 1.45% for both, with no wage limit. An employee is also subject to a 0.9% Additional Medicare Tax on wages that exceed certain thresholds, such as $200,000 for single filers; there is no employer match for this tax. In contrast, distributions paid to a shareholder from the company’s profits are not subject to these payroll taxes.

This difference creates a tax-saving incentive to classify payments as distributions. For example, if an S corp has $150,000 in net income, and the owner takes a $60,000 salary and a $90,000 distribution, the S corp and owner each pay $4,590 in FICA taxes on the salary. If the owner took the entire $150,000 as a distribution with no salary, they would improperly avoid $22,950 in FICA taxes, which is why the IRS requires a reasonable salary.

Factors Used to Determine Reasonableness

The IRS does not provide a specific formula for calculating reasonable compensation, as the determination is based on the facts and circumstances of each case. Courts and the IRS look at a variety of factors to assess if a salary is appropriate for the services performed.

Training and Experience

A primary consideration is the shareholder’s background, including their formal education, professional certifications, and years of experience in the industry. A shareholder with advanced degrees, specialized training, and a long track record of success in their field can justify a higher salary than someone with less experience.

Duties and Responsibilities

The specific roles and responsibilities the shareholder undertakes within the business are a major factor. This includes not just their primary duties but also any administrative or managerial functions they perform. A shareholder who is responsible for strategic planning, financial management, sales, and daily operations is performing the work of multiple employees and can command a higher salary.

Time and Effort Devoted to the Business

The amount of time a shareholder dedicates to the business is another consideration. A full-time commitment, often exceeding a standard 40-hour work week, warrants a higher level of compensation than a part-time role.

Compensation Paid to Non-Shareholder Employees

One of the most direct comparisons the IRS can make is to look at the salaries paid to other employees within the same company. If a non-shareholder employee with similar qualifications and responsibilities is paid a certain salary, it becomes difficult to justify paying the shareholder-employee significantly less for performing comparable or more extensive work.

Payments for Similar Services in Comparable Businesses

The IRS also looks externally to determine what other businesses in the same industry and geographic area are paying for similar services. This involves comparing the shareholder-employee’s role to similar positions in companies of a comparable size and revenue.

The Character and Condition of the Company

The financial health and overall condition of the business play a part in determining a reasonable salary. A highly profitable and growing company is expected to pay its key employees, including shareholders, more than a business that is struggling or just starting out.

Methods for Calculating a Compensation Figure

While the IRS does not endorse one method for calculating a reasonable salary, several approaches can be used to arrive at a defensible figure. Using a combination of these methods can provide a stronger justification for the chosen salary.

A widely used method is the market approach, which focuses on external data to determine a fair salary. This involves researching what comparable businesses pay for similar services. Owners can use publicly available salary data from sources like the U.S. Bureau of Labor Statistics, which provides detailed wage data by occupation and location. Commercial salary websites and industry-specific surveys also offer valuable compensation benchmarks. This data should be adjusted for factors like geographic location, company size, and the shareholder’s specific duties.

Another effective method is a multi-factor approach, which involves a more internal and qualitative analysis. With this method, the shareholder-employee evaluates their role against the various factors the IRS considers, assigning a value or weight to their experience, the complexity of their duties, time commitment, and overall contribution to the company’s success.

The IRS does not recognize arbitrary percentage-based methods like the “60/40 rule,” where 60% of net income is salary and 40% is a distribution. Relying on such a formula is risky because it fails to account for the specific facts and circumstances of the business or the shareholder’s role, and it cannot replace a thorough analysis.

Documenting Your Compensation Decision

After determining a reasonable salary, you must formally document the decision-making process. This documentation is a business’s best defense if its compensation practices are questioned by the IRS, as it shows the salary was the result of a deliberate analysis.

Official corporate minutes are an important piece of documentation. The S corporation’s board of directors should hold a formal meeting to approve the salary. The minutes should record the date, attendees, compensation amount, and a summary of the basis for the decision.

In addition to minutes, prepare a compensation analysis or memo. This document should detail the methodology used to arrive at the salary figure. It can outline the market data reviewed, the factors considered, and how they were applied to the shareholder’s situation.

Consequences of Non-Compliance

Failing to pay a reasonable salary can lead to financial consequences. If an S corporation’s compensation is audited and found unreasonable, the IRS has the authority to reclassify shareholder distributions as wages.

The most immediate impact is the assessment of back payroll taxes. The IRS will require the S corporation to pay both the employer’s and the employee’s share of the unpaid Social Security and Medicare taxes on the reclassified amount.

In addition to back taxes, the IRS will impose penalties. These can include failure-to-pay penalties for not remitting payroll taxes on time and failure-to-deposit penalties for not making timely payroll tax deposits.

Finally, interest will accrue on both the unpaid taxes and penalties from the date they were originally due. The IRS charges interest on underpayments, and this interest compounds daily.