How much salary is "reasonable" for my S-corp — will the IRS come after me if it's too low?
The IRS's S-corp compensation guidance lists the factors it considers when judging whether a salary is reasonable:
What the IRS actually looks at
The IRS's S-corp compensation guidance lists the factors it considers when judging whether a salary is reasonable:
| Factor | What it means in practice |
|---|---|
| Duties and responsibilities | What you actually do day-to-day |
| Time and effort devoted | Full-time vs. a few hours a month |
| Training and experience | Education, credentials, years in the field |
| What comparable businesses pay | Market salary for the same role in your area |
| Payments to non-shareholder employees | What you pay others doing similar work |
| Dividend/distribution history | Large distributions + tiny salary = red flag |
| Compensation agreements, formulas, bonus timing | How pay is actually determined |
The core test, per IRS guidance: to the extent gross receipts come from your personal services, payments to you should be wages subject to employment taxes. To the extent receipts come from other employees, capital, or equipment, distributions are fine. For a one-person consultancy where you are the business, almost all income traces to your services — so your salary should reflect that.
The red flags that draw scrutiny
| Pattern | Why it worries the IRS |
|---|---|
| $0 salary with large distributions | The classic trigger — courts consistently rule against this |
| Salary far below market for the role | e.g., a $90K-market-rate consultant paying themselves $30K |
| Salary unchanged for years while profits soar | Suggests the number isn't tied to actual work value |
| One lump-sum "payroll" in December | Looks like an afterthought, not real payroll |
| Every dollar labeled "distribution" | Veterinary Surgical Consultants (2001) rejected exactly this argument |
Real consequences: in Watson v. Commissioner (2012), a CPA with $200,000+ in S-corp profit paid himself $24,000 in salary; the Tax Court allowed the IRS to recharacterize $67,044 of distributions as wages, adding employment taxes plus interest and penalties.
How to set (and defend) a reasonable salary
- Start from market data, not a ratio. Check BLS wage data, Glassdoor, or Payscale for your role and metro area. The "50–60% of profit" rule of thumb is a sanity check, not a legal standard.
- Document your reasoning. Write down the comparable roles you used, your hours, duties, and experience. This memo is what you'd show an examiner.
- Run real payroll. Monthly or biweekly through a payroll service, with quarterly Forms 941 and an annual W-2 — not a single December check.
- Revisit annually. If profit doubles, revisit the salary; a number that never moves looks arbitrary.
- Consider a formal study. For higher-income S-corps, a third-party reasonable-compensation report (a few hundred dollars) is the strongest evidence.
Erring slightly high costs you a bit more payroll tax; erring too low risks recharacterization. When in doubt, the conservative direction is up.
Frequently asked questions
Is there an IRS-approved percentage, like 60% salary / 40% distributions?
No. No statute, regulation, or IRS publication sets a fixed percentage — "60/40" is industry folklore. Courts decide on facts and circumstances using the factors above. A $300K-profit business with a $60K salary (20%) is much harder to defend than a $100K-profit business with a $60K salary.
Can I take zero salary if the S-corp had a loss year?
Only if you genuinely performed little or no services — which is rare for an owner-operator. If you're still working in the business during a loss year, the IRS can still expect a reasonable salary, potentially funded by capital contributions. Treasury regulations excuse only officers who perform no (or only minor) services.
Does my health insurance count toward reasonable compensation?
Health premiums for >2% shareholder-employees must be added to W-2 Box 1 wages (but not Boxes 3/5, so they're not subject to Social Security/Medicare tax), then deducted on your personal return. They don't substitute for a reasonable salary.
Sources
- https://us-wealth-guide.com/2026-scorp-tax-savings/
- IRS: S Corporation Compensation and Medical Insurance Issues — https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues
- IRS Fact Sheet FS-08-25 (reasonable compensation factors; Rev. Rul. 74-44) — https://www.irs.gov/pub/irs-news/fs-08-25.pdf
- David E. Watson, P.C. v. United States, 2012 (Tax Court upheld recharacterization)