Tax Tip Tuesday: The IRS Has a Question for Every S-Corp Owner: Are You Paying Yourself Enough?

If you own an S corporation and take distributions, there's one number the IRS watches more closely than almost any other: your salary. Specifically, whether it's reasonable.

Getting this wrong isn't just a technicality — it's one of the most common (and costly) audit triggers for small business owners.

What Is Reasonable Compensation?

The IRS requires that S-corporation shareholder-employees who perform services for the company pay themselves a reasonable salary before taking distributions. That salary is subject to payroll taxes. Distributions, on the other hand, are not.

That gap is exactly why some owners try to keep their salary low and distributions high. The IRS knows this — and auditors are trained to spot it.

There's no magic formula. "Reasonable" means what you would pay someone else to do the same work in the same market. It depends on your industry, your geographic area, your qualifications, the hours you put in, and what your business actually earns.

Why This Matters: The Payroll Tax Gap

When you receive W-2 wages as an S-corp shareholder-employee, the company pays 7.65% in payroll taxes and so do you — a combined 15.3% on wages up to the Social Security wage base, plus 2.9% Medicare on amounts above that.

Distributions don't go through that same process. That's perfectly legal — as long as your salary is reasonable first.

When the salary is artificially low, the IRS can reclassify distributions as wages, assess back payroll taxes, add penalties, and charge interest. The exposure can reach back three years — or more if fraud is involved.

A Quick Self-Check

Ask yourself these questions about your current setup:

• Does your salary reflect the actual work you do? If you're running operations, managing clients, and handling strategy — your salary should reflect a market rate for all of those roles.

  
  

• Is your salary lower than what you'd pay an employee to do your job? If the answer is yes, that's a red flag.

  
  

• Do your distributions significantly exceed your salary? A large ratio of distributions to wages tends to draw scrutiny.

  
  

• Has your salary stayed flat while profits have grown? That pattern can look like intentional avoidance — even if it wasn't.

There's no bright-line test, but a 60/40 split (salary to distributions) is sometimes cited as a rough starting point. In reality, the right ratio depends entirely on your facts and circumstances.

What Documentation Should You Have?

If the IRS asks, you want to be able to show your work. That typically means:

• A written compensation analysis or memo explaining how the salary was determined

  
  

• Market data — salary surveys, comparable job postings, or industry benchmarks

  
  

• Documentation of your actual duties and hours

  
  

• Consistent payroll records that match your W-2 and your 1120-S

This doesn't need to be elaborate, but it should exist. A salary set with no documentation is much harder to defend.

Common Situations That Raise the Stakes

Reasonable compensation issues tend to surface in a few specific scenarios:

Profitable S-corps paying zero salary. 

Some owners skip payroll entirely and take only distributions. This is almost always incorrect — if you're working in the business, some portion of what you receive is wages.

Rapid profit growth without salary adjustments. If your business has doubled in revenue but your salary hasn't moved in three years, that's worth revisiting.

S-corps with losses. A salary is still required even in years with losses, if you're performing services. The obligation doesn't disappear because the business isn't profitable.

Mid-year S-corp elections. If you recently converted from an LLC to an S-corp, make sure payroll was set up and salary payments began from the election date — not just January 1 of the following year.

What You Should Do Before Year-End

Reasonable compensation isn't something to set and forget. It should be reviewed at

least once a year — ideally before the end of the tax year, when there's still time to make adjustments.

If you haven't looked at your salary structure recently, or if your business has grown significantly, now is the time. Waiting until your return is prepared limits your options.

MKHS Tax Group works with S-corporation owners throughout the year — not just at tax time. If you want a second set of eyes on your compensation structure, reach out to us at info@mkhstaxgroup.com.