One of the biggest reasons business owners elect S-corp status is the potential to save on self-employment tax, but that savings only works if you handle owner compensation correctly, and the IRS has clear expectations about that.
Here's the rule: if you're a shareholder of an S-corp and you perform services for the business, the IRS says you're an employee, and your compensation for that work has to be paid as wages, subject to Social Security and Medicare tax, before any additional profit gets paid out to you as a distribution. Distributions aren't subject to self-employment tax, which is exactly why some owners are tempted to take a small salary and a large distribution. The IRS calls this out directly and can recharacterize distributions as wages when the salary looks unreasonably low for the work being done.
So what counts as "reasonable"? There's no single formula. The IRS and the courts look at factors like your training and experience, your duties and time commitment, the history of dividends paid by the company, what comparable businesses pay employees doing similar work, and whether the company has any formal compensation policy. In other words: what would you have to pay someone else to do your job?
This matters because getting it wrong has real consequences. If the IRS successfully argues your salary was unreasonably low, it can reclassify distributions as wages retroactively, which means back payroll taxes, penalties, and interest, not just for you but potentially for the business. On the flip side, paying yourself an inflated salary means paying more payroll tax than necessary.
There's no shortcut that avoids judgment here, it takes an honest look at what your role is actually worth in the market, updated as your business changes. We help S-corp clients set, and periodically revisit, a defensible number as part of our tax planning work, rather than picking a figure once and never touching it again.
If you haven't reviewed your S-corp compensation in a while, or you're not sure your number would hold up, let's talk it through.
