Many small business owners choose the S corporation tax classification for its tax advantages, but those benefits only apply when you follow IRS guidelines. A key requirement is that every S corporation owner who performs work for the business must receive reasonable compensation for their services.
In simple terms, your pay must align with what similar businesses would pay for comparable work. Once you have paid yourself a fair salary, you can distribute additional profits to yourself at a lower tax rate.
This article explains how to determine a reasonable S corporation salary, accepted methods you can use, and how to stay compliant with the IRS.
How do S corp owners get paid?
An S corporation is a pass-through entity, which means its income and deductions are reported by the shareholders rather than taxed at the corporate level. Owners who work in the business receive both a salary and potential distributions.
Types of S corporation income:
Type | Description | Tax treatment |
Salary | Regular wages for your role as an employee | Subject to payroll taxes |
Distribution | Profits paid to owners after reasonable salary is met | Not subject to payroll taxes |
This distinction creates the tax advantage that attracts many business owners to S corporation status. While salary is subject to Social Security and Medicare taxes, distributions are not. However, the IRS requires that you pay yourself reasonable compensation first before taking distributions.
Taking all income as distributions and no salary is considered noncompliant and may trigger penalties.
Methods to determine reasonable salary
The IRS does not provide a strict formula for setting compensation. Instead, you must use logical and well documented methods to establish that your pay reflects market value. The three most accepted approaches are the market approach, the cost approach, and the income approach.
Market approach
This method estimates your salary based on what similar roles earn in comparable companies. It is useful for owners with clearly defined job titles or industry standards.
Data sources include:
ZipRecruiter salary insights for regional benchmarks
For example, if you own a small design agency and spend most of your time managing projects, look up what agency managers in your area typically earn and use that range as your salary baseline.
Cost approach
Also called the “many hats” method, this approach works for owners who perform multiple roles. You estimate how much time you spend on each function, assign a fair wage for each, and total those amounts for your annual salary.
Example:
Role | Percentage of time | Comparable salary | Weighted value |
Graphic designer | 60% | 70,000 | 42,000 |
Office manager | 30% | 55,000 | 16,500 |
Marketing coordinator | 10% | 60,000 | 6,000 |
Total reasonable salary | — | — | 64,500 |
This method helps show the IRS that your salary reflects the variety of work you perform for the company.
Income approach
This method focuses on the financial performance of your business. You view your pay as if an outside investor were evaluating the return on investment. If your salary is so high that it would reduce the investor’s expected return, it may not be reasonable. Conversely, if your pay is modest and leaves room for a fair return, it supports the reasonableness of your compensation.
This approach is more subjective and often used when comparable salary data is limited.
Adjust for your circumstances
You can fine tune your salary using several IRS recognized factors. These include:
Your experience and training
The amount of time and effort you devote to the business
Your responsibilities and decision making authority
Business size and profitability
What similar businesses pay for similar work
The company’s dividend and bonus history
Compensation of nonowner employees
For instance, you may set a lower salary if you work part time, employ staff who perform key duties, or if your business is still early in its growth stage. Always document how you arrived at your final figure in case of an IRS review.
What about the 60/40 rule?
The 60/40 guideline suggests dividing business income so that 60% goes to salary and 40% to distributions. While common in online discussions, this rule is not recognized by the IRS.
Your pay must be based on market standards and business conditions, not on arbitrary percentages. Using fixed ratios may fail an audit if your compensation does not match what others in your field earn.
How often should you pay yourself?
You can choose your payroll frequency based on cash flow. Owners typically pay themselves semi-monthly or monthly, but you can also use quarterly or annual payroll runs if your business income is irregular.
Distributions can be taken at any time during the year. The key is to ensure that payroll taxes are properly withheld and remitted on each paycheck.
It is also acceptable to pay a smaller salary throughout the year and issue a year end bonus once total profits are known. Just ensure that total annual pay remains reasonable for your role and document any adjustments.
Pro tip: Review your salary annually. Increases in revenue, workload, or responsibility may justify a higher wage.
What happens if you do not follow compliance rules?
If the IRS determines that you underpaid yourself and took too much income as distributions, it can reclassify part of those distributions as wages. This means you will owe back payroll taxes along with penalties and interest.
The agency uses audits and comparison data to identify S corporations where owner compensation appears low relative to revenue. Maintaining documentation of your salary calculations can protect you from reclassification risk.
FAQs
Is there a minimum salary for S corporation owners?
No specific minimum exists. The amount must be reasonable for your role, industry, and region.
Can I pay myself a different salary every year?
Yes, you can adjust annually as business conditions change. Keep supporting data each year.
Do I have to pay myself if my S corporation has no profit?
No. If the business does not generate revenue, you are not required to take a salary until income is earned.
Are distributions always tax free?
Distributions are not subject to payroll taxes, but they are still taxed as ordinary income on your personal return.
Can I pay myself quarterly instead of monthly?
Yes, as long as payroll taxes are deposited on time and your compensation remains reasonable.
Video: Figure Out Your Reasonable Salary
What Salary Should S Corp Owners REALLY Be Paying Themselves?
