S-Corp Reasonable Salary: What the IRS Looks For (and Where Owners Go Wrong)

Last week I got off a call with a client who had been running his S-Corp for three years. Good revenue — about $280K net. He paid himself a salary of $24,000 the whole time.

He thought he was saving on payroll taxes. He was right — for three years. Then the IRS letter showed up.

That’s the thing about the S-Corp reasonable salary rule. It’s not complicated. It doesn’t hurt until it does — and then it really does.

The Salary Paradox

The more aggressively you underpay yourself to avoid FICA taxes, the more you invite the IRS in. Every dollar below reasonable compensation looks, to the IRS, like a concealed distribution designed to dodge self-employment tax (IRC §3101, §3111).

I call this The Salary Paradox: the move that feels like savings today is the liability that surfaces at the worst possible time — usually during an audit, a loan application, or a business sale.

Paying less now sets you up to pay far more later. Paying yourself right makes the structure work.

“But I’m Just Minimizing My Tax Burden”

This is the objection I hear constantly, and honestly — it’s not wrong in principle. S-Corp election exists to help owners reduce self-employment tax by splitting income between salary (subject to FICA) and distributions (not subject to FICA). That’s legitimate. That’s the whole point.

The problem isn’t using the split. The problem is pushing your salary so low it no longer passes the IRS’s basic smell test.

You Already Know This

You’ve felt this instinctively. Every time someone at a networking event brags about paying themselves $1 and taking everything as distributions, something probably felt off. That instinct is correct. The IRS has litigated this exact position dozens of times and won most of them.

What “Reasonable” Actually Means

The IRS doesn’t define a specific number — which is, frankly, a crap way to enforce a rule. What they do is look at what you’d have to pay someone else to do your job. Courts have consistently applied a multi-factor test (Spicer Accounting, Inc. v. United States, 918 F.2d 90), examining:

• What comparable businesses pay for similar roles in your industry
• Your training, experience, and actual duties performed
• Time devoted to the business
• Dividend history — is salary being replaced by distributions?
• How your compensation compares to non-shareholder employees

Under IRC §7436, the IRS can reclassify distributions as wages, assess back FICA on the full reclassified amount, add interest, and stack penalties. A client I worked with last year owed more in penalties and interest than the original tax savings were worth — by a wide margin.

What to Do About It — 5 Concrete Steps

1. Benchmark your salary against real data. Use BLS Occupational Employment Statistics or a professional compensation report for your industry and geography. Document it. If you’re ever questioned, this is your first line of defense.
2. Run actual payroll — not year-end adjustments. S-Corps must pay compensation through payroll on a regular schedule (IRC §3121). Informal draws recharacterized as salary at year-end are a red flag.
3. Use the 60/40 heuristic as a starting point. Not law — just a practical benchmark: salary should be roughly 60% of your net S-Corp income. It signals you’re not gaming the structure.
4. Scale your salary as revenue grows. A $40K salary on $150K net is defensible. The same salary on $400K net is an audit target. Review it every year.
5. Act before your return goes in. If you filed an extension this April, you still have time to get this right before the return is finalized. Don’t lock in an exposed position.

The Bottom Line

If the IRS audited your S-Corp tomorrow and asked you to document why your salary is what it is, could you do it? Not in theory — today, with what you have on hand? If the answer is no, that’s the only thing you need to fix this week.

L’hitraot,
Alad

Alad Adar is an Enrolled Agent (EA) and owner of A Plus Tax & Accounting, LLC — serving business owners virtually in all 50 states. Book a free consultation at aplustaxhelp.com.

Running an S-Corp and not sure your salary passes the IRS test? Our international tax strategy and business consulting service helps S-Corp owners set a defensible reasonable salary — before the IRS asks.