Are You Paying Yourself Enough to Stay Out of IRS Trouble?
If you’re an S Corp owner wondering whether your salary will trigger an audit, the numbers might surprise you. According to Treasury Inspector General data, the IRS examines only 0.1% of S Corporation returns annually for reasonable compensation issues¹—but nearly half of all S Corporations (49.5%) report no officer compensation whatsoever,1 with government analysis suggesting billions in employment taxes are being avoided.
You know you need to pay yourself a “reasonable” salary before taking distributions, but what does that mean in dollars and cents? The IRS doesn’t publish a magic formula, but there are clear guidelines, real court cases, and proven strategies that can help you understand what they’re looking for. This guide explains the key concepts involved, though given the high stakes and complexity, most S Corp owners benefit from working with a CPA who specializes in S Corporation taxation.
Key Takeaways:
- The real consequences of underpaying or overpaying yourself
- The multi-factor test the IRS uses to evaluate your compensation
- The systematic process for setting a defensible salary
- What to expect if your compensation is challenged
- Solutions to the most frequent reasonable compensation dilemmas
- How specialized S Corp CPAs can protect your interests
Why Getting Your S Corp Salary Right Matters
The IRS has identified S Corp salary compliance as a priority area, launching a new enforcement initiative in 2020 focused on businesses that report no officer compensation.1 But the flip side (paying yourself too much) means unnecessarily high payroll taxes that eat into your profits.
Consider what happened to David Watson, a successful CPA who thought he had found the perfect loophole. Watson’s accounting firm was generating nearly $3 million in revenue, but he paid himself just $24,000 per year in salary, taking the rest as distributions. The IRS disagreed with his strategy and reclassified some of his distributions as wages, ultimately winning the case in the 8th Circuit Court of Appeals and hitting Watson with back taxes, penalties, and interest.2
The lesson for other S Corp owners: You can’t game the system by paying yourself an artificially low salary. But you also don’t need to overpay and give the government more than required.
What Happens When You Get It Wrong
There are three major pitfalls in misjudging your reasonable salary. Each one can have different and dramatic consequences for your business.
Common Reasonable Compensation Errors and Consequences
| Error | Typical Consequences |
|---|---|
| Pay Too Low | IRS audits and reclassification of distributions as wages Back payroll taxes, penalties, and interest Potential criminal charges in extreme cases |
| Pay Too High | Unnecessary payroll taxes (15.3% on salary vs. 0% on distributions) Reduced cash flow and business growth capital Lower net income and personal wealth accumulation |
| Skip Documentation | Inability to defend your salary decision during an audit Higher likelihood of IRS adjustments Increased penalties and professional costs |
The good news is that most reasonable compensation disputes can be avoided with proper planning and documentation from the start.
What the IRS Really Wants: The 2025 Rules Explained
While many business owners expect a clear formula, the IRS doesn’t actually offer a foolproof calculation for figuring reasonable compensation. Instead, they rely on a multi-factor test that examines the economic reality of your situation. Understanding these factors is the first step to setting a defensible salary.
The IRS expects your S Corp salary to match what you’d pay an unrelated employee to perform your same duties. This “hypothetical employee” test forms the foundation of all reasonable compensation analysis.
The key factors the IRS considers:
- Your Role and Responsibilities: What do you actually do in the business? A CEO managing 20 employees deserves different compensation than a solo consultant working from home. The IRS wants to see a detailed job description that reflects your real duties, not just your official title
- Experience and Qualifications: Your professional background directly impacts reasonable compensation. A CPA with 20 years of experience commands higher wages than someone fresh out of college, even if they’re doing similar work.
- Time Commitment: Full-time owners should receive full-time compensation. If you’re working 50 hours per week, your salary should reflect that commitment. Part-time involvement justifies proportionally lower wages.
- Market Rates: The IRS wants to see that your compensation aligns with what similar businesses pay for similar roles in your geographic area.
- Company Performance: Highly profitable companies typically pay their key employees more than struggling businesses. Your salary should bear some relationship to the company’s financial success.
Take the case of Sean McAlary, a real estate broker who paid himself nothing while his S Corporation generated $231,454 in profit during 2006. When the IRS challenged his compensation, they brought in an expert who determined that real estate brokers in his Southern California area earned $48.44 per hour, translating to $100,755 annually (using the standard 2,080 hours per year). The Tax Court ultimately settled on $83,200 as reasonable compensation ($40 per hour), balancing market rates with the specific circumstances of his business.3
How to Determine Your Reasonable Salary: A Step-by-Step Approach
Setting your S Corp salary doesn’t have to be guesswork. Here’s a systematic approach that should help you arrive at a defensible number while maintaining detailed documentation.
Step 1: Document Your Actual Job
Start by creating a detailed job description that reflects what you really do, not what your business card says. Include specific responsibilities, decision-making authority, and time allocation for different activities.
For example, if you’re a marketing consultant, your documentation might show that you spend:
- 40% of your time on client strategy
- 25% on business development
- 20% on project management
- 15% on administrative tasks
This level of detail helps justify your compensation and demonstrates that you’re not just a passive investor.
Step 2: Research Market Compensation
Use reliable sources to find comparable salaries in your area and industry. The Bureau of Labor Statistics provides excellent baseline data, but don’t stop there. Industry associations, salary surveys, and local employment websites can provide additional context.
Remember that you’re looking for compensation data for employees, not business owners. The IRS wants to know what you’d pay someone else to do your job, not what other business owners are earning.
Step 3: Adjust for Your Specific Circumstances
Raw market data is just the starting point. You’ll need to adjust up or down based on your specific situation:
- Experience level: More experienced professionals command higher salaries
- Geographic location: Adjust for local cost of living variations
- Company size: Smaller companies typically pay less than large corporations
- Industry specialization: Niche expertise may justify premium compensation
- Hours worked: Part-time involvement means proportionally lower wages
Step 4: Consider Your Company’s Financials
Your salary should be related to your company’s ability to pay. A business generating $100,000 in profit can’t reasonably justify a $150,000 salary for its owner. However, highly profitable businesses should expect to pay market rates or higher for key personnel.
Step 5: Document Your Decision
Create a written memo explaining your salary determination. Include your job description, market research sources, adjustment factors, and final rationale. This documentation will be invaluable if the IRS ever questions your compensation.
When the IRS Comes Knocking: The Audit Process
Understanding the process can help you respond effectively and potentially resolve the matter without significant penalties if the IRS decides to challenge your S Corp salary.
The process typically begins when your compensation catches an auditor’s attention during a routine review. Red flags include salaries that seem unusually low compared to distributions, compensation that’s far below industry standards, or patterns that suggest tax avoidance rather than legitimate business planning.
- Initial Contact: You’ll receive a letter requesting documentation about your salary decision. This is often just an information request, not a full audit notice. Many cases end here if your documentation is thorough and reasonable.
- Documentation Review: The IRS examiner will evaluate whether your salary aligns with your documented duties and local market rates. They’re looking for evidence that your compensation represents fair value for services performed.
- Expert Analysis: In complex cases, the IRS may hire valuation experts to determine appropriate compensation ranges. These experts typically rely on Bureau of Labor Statistics data and industry surveys to establish market benchmarks.
- Negotiation Opportunity: Most reasonable compensation inquiries are resolved through discussion rather than formal litigation. The IRS often accepts compromise settlements if your documentation supports your position and you’re willing to make reasonable adjustments.
- Resolution: The process typically takes 3 to 6 months from initial contact to final resolution. Taxpayers who cooperate and provide solid documentation usually avoid significant penalties, even if some salary adjustment is required.
The key to surviving an IRS inquiry is preparation. If you’ve documented your salary decision and can demonstrate that it reflects fair market value for your services, you’re likely to emerge with minimal damage.
Frequently Asked Questions About Reasonable Salary Requirements
Here are the most common questions S Corp owners ask about reasonable compensation, along with practical answers that can help guide your decision-making process.
What if my profit is less than a reasonable salary?
Pay as much as your business can reasonably afford, and document your reasoning. The IRS understands that struggling businesses may not be able to pay full market rates, but you should still pay some salary if the business has any profit. Consider whether you’re truly working full-time if your business can’t support a living wage.
Can I take all my profit as distributions?
No. The IRS requires S Corp owner-employees to receive reasonable compensation for services performed before taking any distributions. This is a fundamental requirement that can’t be avoided through creative structuring.
How often should I review my salary?
At least annually, and whenever your role or company performance changes significantly. Market rates evolve, and your responsibilities may expand as your business grows. Regular reviews demonstrate good faith compliance and help you stay current with changing circumstances.
What documentation should I maintain?
Keep records of your job description, time logs showing hours worked, salary research and sources used, written justification for your salary decision, and annual compensation reviews. This documentation package will be invaluable if the IRS ever questions your compensation.
Should I match the highest market rate I can find?
Not necessarily. Reasonable compensation means fair market value, not maximum possible compensation. Consider your company’s size, profitability, and specific circumstances when setting your salary. Paying significantly above market rates may trigger different IRS concerns about unreasonable compensation.
Working with Professional Advisors
While you can research and set your reasonable salary independently, working with experienced tax professionals can provide valuable guidance and peace of mind. CPAs who specialize in S Corporation taxation understand the nuances of reasonable compensation and can help you navigate complex situations. The cost of professional guidance is often minimal compared to the potential consequences of getting it wrong.
Bluegrass Professional Associates brings specialized S Corporation expertise and documented methodologies to help business owners establish defensible compensation strategies. With 25+ years of experience in professional service taxation, we understand how to balance IRS compliance with tax optimization goals.
Ready to establish a defensible S Corp salary strategy? Contact Bluegrass Professional Associates today to review your compensation structure and ensure you’re meeting reasonable salary requirements while maximizing your tax benefits. Our S Corporation specialists can help you document your decision and provide ongoing guidance as your business evolves.
Sources
- TIGTA Report 2021-30-042, “Efforts to Address the Compliance Risk of Underreporting of S Corporation Officers’ Compensation” (2021)
- Charles J. Reichert, “Eighth Circuit agrees that CPA was underpaid,” Journal of Accountancy (May 2012), available at: https://www.journalofaccountancy.com/issues/2012/may/reasonable-compensation-may-2012/
- Sean McAlary Ltd. Inc. v. Commissioner, Tax Court Summary Opinion 2013-62; Paul Hamann, “McAlary v. IRS,” RCReports (Sept. 1, 2013), https://rcreports.com/archived/mcalary-v-irs/
This guide provides general information about S Corporation reasonable compensation requirements. Individual circumstances vary, and professional advice is recommended for specific situations. Contact Matthew L. Ward, CPA at Bluegrass Professional Associates for a free consultation.