Most small businesses find it most advantageous to establish an LLC as the legal entity and then file for S-Corp tax status when appropriate. Many businesses choose to be taxed as an S Corporation (or “S-Corp”) which has some advantages when it comes to taxation. Social Security benefits are calculated based on your salary, not distributions. Then, take all other compensation in the form of distributions. It makes good business sense to consult a tax professional to optimize your S Corp’s overall tax benefits and remain compliant with tax laws. Doing so entails keeping adequate records, correctly reporting salaries and distributions, and filing your tax documents on time.

Key Factors That Determine Reasonable Compensation

Documentation created after the fact carries much less weight than records maintained as part of your normal business practices. Save minutes from board meetings where compensation was approved, and maintain copies of employment agreements. This starts with keeping detailed records of your duties and time commitment to the business. This looks like an afterthought – a last-minute attempt to satisfy requirements rather than legitimate compensation. The IRS has never endorsed this or any similar ratio as a “safe harbor.” Each business gets evaluated based on its own specific circumstances, not a one-size-fits-all formula. The IRS doesn’t just look at your salary in isolation – they see the whole picture.

What Is an S Corp “Reasonable Salary”? How to Pay Yourself the Right Way

• After salaries and other expenses, the company’s profits are passed through to shareholders and reported on individual income tax returns.
• Penalties can include back taxes, interest, and fines for the underpayment of payroll taxes, along with the risk of an audit.
• This will enable you to remain compliant with the IRS and minimize the amount of payroll taxes incurred.”
• If you’re providing real services, you must pay real compensation.
• An LLC with multiple members may elect S Corporation tax status if the LLC has 100 or fewer members and meets the IRS’s other S Corporation eligibility requirements.

While no fixed percentage exists, extremely low salary-to-profit ratios attract scrutiny. This research forms the foundation of defensible S Corp tax filing. Maintain time logs documenting hours worked, particularly if you work part-time or have multiple businesses. The IRS expects compensation to reflect actual time commitment. Document the specific duties you perform, hours worked, and business functions you handle personally versus delegate.

Expert support for small businesses to resolve IRS issues and reduce back tax liabilities Catch up bookkeeping services for small businesses, no matter how far behind they are Periodically, you should compare your year-to-date wages against distributions. Your ledger is the perfect tool for maintaining a clear line between wages and distributions.

What salary strategy minimizes audit risk in 2025?

This is far from the concrete answer shareholders might hope for. Any shareholder-employees must be treated as an employee. This is called being a shareholder-employee.

S Corporations and Taxes

In fact, it’s estimated that over 50% of S corps are not paying their owners adequate compensation, triggering millions in unpaid payroll taxes annually. This concept prevents S-Corp owners from avoiding payroll taxes by taking distributions instead of a salary. At its core, reasonable compensation is the salary that an S-Corp shareholder-employee must take for the services they provide to the business. NSKT Global specializes in s corp reasonable compensation analysis, helping business owners maximize tax savings while maintaining full IRS compliance.

Consultation with Tax Professionals

With early stage businesses, it’s common for shareholders to hold positions in their own company. This example shows a monthly payroll run for a $150,000 annual salary ($12,500/month), followed by a separate owner distribution. For context, the 2025 payroll tax rates are 6.2% for Social Security on wages up to $176,100 and 1.45% for Medicare on all wages. The court sided with the IRS, recharacterizing most of those distributions as wages subject to employment taxes.

Free Course: Understanding Financial Statements

Just like any other employee would, you have to report your salary on your taxes. You need to operate like a business with employees, even if you’re the only one on the payroll. You could pay more in taxes than necessary, risk penalties for low-balling your pay or end up with unused money in the company.

Owning a business comes with all sorts of challenges to navigate. Learn how to create an employee code of conduct policy by setting clear expectations, promoting ethical behavior, and protecting your workplace. He has over 15 years of experience writing for small and growing businesses. Many entrepreneurs choose S Corps for their tax benefits and limited liability protections. Strive to establish a fair salary that is in line with peer group norms for the kind of work you do.

Current developments in taxation of individuals: Part 2

• Don’t wait for an IRS notice to address reasonable compensation.
• Understanding reasonable compensation is important for owners of S corporations who are paid a salary to determine what their W-2 should say at the end of the year.
• On its website, the IRS cites the Watson case and several others as “supporting the authority of the IRS to reclassify other forms of payment to a shareholder-employee as a wage expense that is subject to employment taxes.”
• The IRS can’t require payments the business can’t afford.
• “As an S Corp owner, you should take a sensible mix of distributions and salary.

One reason LLC and C Corp owners elect the S Corp structure to avoid double taxation on the corporate income. Setting reasonable compensation as an S corp owner can be complex and fact-specific. Reasonable compensation for S corp owner-employees is a hot button issue with the IRS, but determining what to pay yourself isn’t always straightforward.

They recategorized the $67,044 difference as wages subject to payroll taxes. Despite providing significant services for the business, for two years he did not pay himself any salary and instead took distributions. Further, evaluating reasonable compensation unearths overall financial and tax planning opportunities, as wages affect contributions to retirement plans and the value of health and retirement benefits.

California S-Corp Salary Requirements

You will need to use IRS Form 1125-E – Compensation of Officers, listing compensation for each corporate officer, along with information about the percentage of time devoted to the business and the percentage of stock owned by this officer. Include these medical/accident insurance payments on the shareholder-employee’s Form W-2, Box 1, but not Boxes 3 and 5. Your ability to prove that officer salaries are reasonable will help keep you on the right side of the IRS when it comes time for them to review your company’s tax returns. Jean Murray is an experienced business writer and teacher who has been writing for The Balance on U.S. business law and taxes since 2008.

Your spouse must receive reasonable compensation for actual services performed. Higher salaries enable larger retirement contributions, potentially offsetting increased payroll taxes. This additional tax applies only to wages, making the salary vs. distribution decision more complex at higher income levels.

Determining a “reasonable salary” is a key requirement for owners of S corporations looking to stay compliant with IRS rules and avoid costly penalties. The IRS examines whether your corporation has a history of paying dividends or only makes distributions to avoid payroll taxes. S Corp reasonable compensation is the amount you would pay an independent third party to perform the same services you provide to your S corporation. Because the owners of an S Corporation are generally considered employees, they do not pay self-employment taxes on their share of the company profits.

Full-time owner-operators working 50+ hours weekly justify significantly higher compensation than part-time shareholders working 10 hours weekly. The tax difference between wages and distributions creates powerful incentives to minimize salary. The IRS prevents this tax reasonable salaries and s corps avoidance by requiring market-rate compensation for services performed. This requirement exists because S corp distributions avoid the 15.3% self-employment tax that applies to wages. Would you owe $26,000 in back payroll taxes plus penalties and interest?