What Counts as a Reasonable Salary for an S Corp Owner

What the Standard Actually Says

The requirement comes from the principle that payments to a shareholder-employee for services are wages, regardless of what the company calls them. The IRS position, set out in Revenue Ruling 74-44 and reinforced across decades of case law, is that reasonable compensation is the value of the services the shareholder actually performs. The practical test is what the business would have to pay an unrelated person to do the same job.

• The standard is the value of services performed, not a share of profit
• It applies to shareholders who work in the business, not to passive shareholders
• It has to be paid as W-2 wages through payroll, not as a distribution or a loan
• The determination is made per year, so it moves as your role and the business change

Why the IRS Cares

Wages carry Social Security and Medicare tax. Distributions do not. Every dollar shifted from salary to distribution avoids roughly 15.3% in combined employment tax up to the Social Security wage base, and 2.9% above it. That gap is the incentive to understate salary, and it is why owner compensation is a standing audit issue.

• Social Security tax applies to wages up to the annual wage base, $184,500 for 2026
• Medicare applies to all wages with no cap, plus an extra 0.9% on employee wages over $200,000
• If the IRS reclassifies distributions as wages, it assesses back employment tax plus penalties and interest
• Understated payroll also reduces your future Social Security benefit, which is a real cost people forget

The Factors That Actually Get Weighed

Because there is no formula, the IRS and the courts look at a list of factors drawn from case law. No single one decides the question, and they are applied to the specific facts of your business. Knowing the list is useful mainly because it tells you what to document.

• Your training, education, and experience
• Your duties and responsibilities within the business
• The time and effort you devote to it
• The dividend and distribution history of the company
• What the business pays non-shareholder employees for comparable work
• The timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Any compensation agreement, and whether a formula was used to set the amount

Why the 60/40 Rule Is Not a Rule

You will see advice suggesting a fixed split, most often 60% of profit as salary and 40% as distributions. No such rule exists in the tax code, in IRS guidance, or in any court decision. It is a convention that circulates because it is easy to remember. Applying it mechanically produces a salary tied to profit rather than to the value of your work, which is precisely the reasoning the standard rejects.

• A profitable year does not automatically make your services more valuable
• A business with a bad year still owes you reasonable pay for the work you did
• Two owners doing identical work should be paid similarly even if their ownership differs
• Tying salary to a percentage of profit is easy to spot and hard to defend

How to Document Your Number

Because the determination is fact-specific, the defensible position is not a particular number but a documented process for reaching it. Build the file at the time you set the salary, not after a notice arrives.

• Write a short job description covering what you actually do and roughly how many hours it takes
• Gather comparable salary data for that role in your industry and geography
• Note the portion of your time spent on activities that generate revenue versus administration
• Record a board or shareholder resolution setting the compensation for the year
• Revisit the number annually and keep each year's support

Get a Professional Opinion on the Number

Everything above describes how the standard works. It does not tell you what your salary should be, because that depends on facts only you and your accountant have. Reasonable compensation studies are a routine service for CPAs working with S corps, and the cost is small next to the exposure of getting it wrong. Treat this guide as background, not as tax advice for your business.