Reasonable Compensation and Your S Corporation

The Appeal — and the Risk

The S-corp structure is attractive because profits passed through to shareholders aren't subject to self-employment tax. Only wages are. So the lower the salary, the less payroll tax.

The IRS knows this. And they've been auditing it for decades.

The requirement is simple in concept: if you're a shareholder-employee performing services for your S-corp, you must pay yourself a reasonable salary before taking distributions. What's "reasonable" is where it gets nuanced.

What the IRS Actually Looks For

The IRS doesn't publish a formula. What they look for is evidence — facts that support the wage paid relative to the work performed.

Key factors they consider:

• What would you pay someone else to do your job?
• What are comparable salaries in your industry and region?
• How much time do you spend in the business?
• What is the business actually generating?
• What's your training, experience, and role?

A $30,000 salary from a business generating $400,000 in net income is a red flag. A $30,000 salary from a business generating $60,000 is a different conversation.

The standard isn't perfection — it's defensibility.

Year One Is Different Than Year Ten

Reasonable compensation isn't a static number. It should scale with your business.

In the early years, when revenue is inconsistent and the business is still finding its footing, a conservative salary is often appropriate. Cash flow constraints are real, and the IRS generally understands that a startup doesn't pay its founder like an established firm.

As the business matures — revenue stabilizes, profit margins improve, the owner's role becomes more defined — the salary should reflect that. A business generating steady six-figure profits year after year with a $40,000 owner salary is hard to defend.

A practical approach: document your reasoning each year. Note the revenue, your role, comparable market rates, and how you arrived at your number. That paper trail matters if questions ever arise.

Medical Premiums — a Detail That's Easy to Get Wrong

If your S-corp pays health insurance premiums for a shareholder-employee who owns more than 2%, those premiums must be included in W-2 wages. They show up in Box 1 as taxable income.

The good news: that same amount is then deductible on your personal return as self-employed health insurance — dollar for dollar, above the line.

The catch: if the premiums aren't included in wages correctly, the deduction on the personal side is disallowed. This is one of the most common and easily avoidable S-corp errors.

The setup matters:

• Premiums should be paid by or reimbursed through the S-corp
• They must be reported on the W-2
• The deduction flows to Schedule 1, not Schedule A

Same result financially — but only if the paperwork is done right.

Why a Higher Salary Isn't Always a Bad Thing

Most S-corp owners focus on minimizing their salary to reduce payroll taxes. That's understandable — but it's not always the right call.

A few reasons a higher salary can work in your favor:

Solo 401(k) and SEP contributions. Retirement plan contributions are based on earned income — which for an S-corp owner means W-2 wages, not distributions. A higher salary increases the ceiling on what you can contribute, which can produce tax savings that outweigh the additional payroll tax.

Social Security credits. Benefits at retirement, disability, and for survivors are based on your earnings record. Years with low or no wages are years with low or no credits. For younger business owners especially, this is worth thinking through before defaulting to the lowest defensible salary.

Loan applications and income verification. Distributions don't always show up cleanly on a mortgage application or financial statement. A documented W-2 salary tells a cleaner story.

The goal isn't to maximize salary for its own sake. It's to find the number that's defensible, appropriate for your stage, and actually optimal when you consider the full picture.

A Reasonable Starting Point

There's no universal answer, but a structured approach helps:

1. Start with comparable data. What does someone in your role, industry, and region earn? BLS wage data, industry surveys, and job postings are all legitimate reference points.
2. Adjust for your actual time. If you're part-time in the business, scale accordingly. If you're wearing five hats, account for that.
3. Factor in business performance. A salary that made sense at $150,000 in revenue may need revisiting at $500,000.
4. Document everything. The reasoning matters as much as the number.
5. Revisit annually. Reasonable compensation isn't a one-time decision.

The Bigger Picture

Reasonable compensation sits at the intersection of payroll tax, retirement planning, benefits, and audit risk. Getting it wrong in either direction has consequences — underpaying invites scrutiny, overpaying unnecessarily increases payroll taxes without a corresponding benefit.

The right number is the one that holds up, serves your planning goals, and reflects what the business actually is today — not what you hope to avoid paying.

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A Note from andromeda

Our goal with andromeda Insights is to help readers better understand complex tax and accounting topics. The information presented here is general in nature and not a substitute for advice tailored to your specific circumstances.

Reading this article does not establish a client relationship. For guidance specific to your situation, consult a qualified professional.