Reasonable compensation requires S-corp owner-employees to pay themselves a fair market salary subject to payroll taxes before taking tax-advantaged distributions.
Why reasonable compensation matters for S-corp owners
S-corporation owners who work in their business must pay themselves a reasonable salary as W-2 wages before taking additional income as distributions. This requirement exists because S-corp distributions are not subject to self-employment or FICA taxes, while W-2 wages are. Without the reasonable compensation rule, owner-employees could take all business income as distributions and pay no payroll taxes.
The IRS defines reasonable compensation as the amount a similarly situated business would pay a non-owner employee for the same services. Factors considered include: the employee's role and responsibilities, time devoted to the business, training and experience, the company's size and complexity, compensation paid by similar companies for similar work, and the history of compensation paid.
There is no specific dollar threshold the IRS uses. The standard is fact-based. Courts have found compensation unreasonably low when S-corp owners took zero or minimal salary while the company generated substantial revenue. Reconstructed wages can be assessed with FICA taxes, interest, and 20% accuracy-related penalties.
Under-compensation also affects retirement plan contributions. Contributions to solo 401(k)s, SEPs, and other qualified plans are based on W-2 compensation. Artificially low salaries reduce allowable contributions.
Over-compensation is also possible - excessive salaries paid to owner-employees may be challenged as unreasonable by the IRS as a disguised dividend to non-shareholder family members. Reasonable compensation works in both directions.
How BEG helps S-corp owners structure payroll correctly
BEG Managed Payroll helps S-corp clients establish and process reasonable compensation schedules, ensuring FICA compliance while maximizing distribution efficiency as part of fully managed payroll at $25-$45 per employee per month. Learn about BEG Managed Payroll.
Frequently asked questions
What happens if an S-corp owner does not take a salary?
The IRS can reclassify distributions as wages, assess FICA taxes on the reconstructed salary, and impose interest and a 20% accuracy-related penalty. Officers who perform services for the corporation must receive reasonable compensation.
How is reasonable compensation determined?
Reasonable compensation is what a comparable business would pay a non-owner employee for the same work. Factors include industry pay data, the owner's role and time commitment, and the corporation's financial performance.
Can an S-corp owner take a very low salary?
The IRS has challenged salaries that are unreasonably low relative to distributions. While there is no specific minimum, paying zero or nominal salary while taking substantial distributions is a significant audit risk.
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About the author
Anthony Moretti is VP of Sales at Business Executive Group, where he builds BEG's managed payroll and HR service verticals for employers across Dallas-Fort Worth and nationwide. He writes the BEG Payroll Glossary to give employers plain-English answers on payroll and compliance.
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