The S corporation is popular for one big reason: profits distributed to owners are not subject to Social Security and Medicare taxes the way a salary is. That creates an obvious temptation — pay yourself a tiny wage and take the rest as distributions. The IRS knows this game well, and the rule that governs it is "reasonable compensation." Understanding it is the difference between a legitimate tax strategy and an audit waiting to happen.
This is general information, not individual tax advice — the right treatment depends on your specific situation.
The Rule in Plain English
If you are a shareholder who works in your S corporation, the IRS requires that you be paid reasonable compensation — a real W-2 salary — for the services you provide before you take non-wage distributions. Wages are subject to payroll taxes: 6.2% Social Security and 1.45% Medicare from the employee, matched by the corporation, for 15.3% combined on the salary portion. Distributions are not. That gap is exactly why the rule exists: it stops owners from re-labeling what is really compensation as a tax-free distribution.
Why a Too-Low Salary Is Dangerous
The IRS has clear authority to reclassify distributions as wages when it decides an owner's salary was unreasonably low. If that happens, you owe the back payroll taxes on the reclassified amount — plus penalties and interest. Courts have repeatedly backed the IRS here. In the well-known David E. Watson, P.C. case, an accountant paid himself a token salary while taking large distributions; the Eighth Circuit upheld the IRS treating tens of thousands of those dollars as wages. The lesson is not "avoid distributions" — it is "pay a defensible salary first."
How the IRS Judges "Reasonable"
There is no magic percentage and no official safe harbor. Instead, the IRS and the courts weigh a set of factors: your training and experience, your duties and responsibilities, the time and effort you devote to the business, what comparable businesses pay for similar work, your dividend and distribution history, compensation paid to non-shareholder employees, and any compensation agreements or formulas you use. A key lens is the source of the company's income: profit generated by your personal services points toward higher required wages, while profit driven by employees, capital, or equipment can reasonably be distributed.
Finding Your Number
A sound approach starts with the question: what would you have to pay someone else to do everything you do for the business? Market salary data for your role, region, and industry is the anchor. Many owners wear several hats — operator, salesperson, technician, manager — so the analysis blends the going rate for each function against the hours you actually spend. The goal is a salary you can document and defend, not the lowest number you think you can slip past the IRS. Keeping a written reasonable-compensation analysis in your files is cheap insurance.
The Ripple Effects Beyond Payroll Tax
Your salary figure influences more than FICA. Retirement-plan contributions to a solo 401(k) or SEP-IRA are based on W-2 wages, so a very low salary can shrink how much you can shelter for retirement. Wages also interact with the qualified business income (QBI) deduction and, for many owners, with health coverage: premiums an S corporation pays for a more-than-2% shareholder are added to W-2 wages (and deductible by the corporation), yet are not hit with Social Security or Medicare tax, and the owner can then claim the self-employed health insurance deduction. These moving parts reward getting the salary right, not just low.
How VarStan Helps
Reasonable compensation is where S-corp tax savings are either earned or lost. As a CPA-led firm, we build a documented, defensible salary figure for each owner using real market data, coordinate it with your distributions, retirement contributions, and health coverage, and keep the analysis on file in case the IRS ever asks. If you own an S corporation — or you are weighing whether the election makes sense for your business — we will make sure your salary is set at a number that holds up. Let's talk before year-end, while there is still time to adjust.