Guide to Calculating Reasonable Compensation for S Corps

An S corp election can be a smart tax-saving move for small business owners. S corps are pass-through entities where profits and losses flow through to owners for handling on their personal income tax returns, avoiding double taxation. By structuring your business this way, you can potentially reduce self-employment taxes and optimize your take-home income. However, with these benefits comes a critical compliance requirement: S corp shareholder employees who provide services must pay themselves a reasonable salary before taking profit distributions.

This rule exists to prevent S corporation owners from classifying all earnings as distributions in order to avoid payroll taxes. Because the IRS closely monitors this area, failing to pay a reasonable salary is one of the most common triggers for an audit of S corporations.

If your S corporation nets $120,000, for example, a reasonable salary might fall between $50,000 and $80,000, depending on the industry and role.

This guide breaks down everything you need to know, including how to calculate a defensible salary, the IRS factors to consider, and how to build airtight documentation that protects your business in an era of AI-powered tax enforcement.

Key Highlights

• S corporation shareholders must pay themselves a reasonable salary before taking distributions.

• The IRS does not provide a strict formula—salary determinations depend on your business’s facts and circumstances.

• Three primary calculation methods exist: the market approach, the cost approach, and the income approach.

• Documenting your role, responsibilities, time commitment, and pay data with comparable businesses is critical for audit defense.

• Shortcuts like the 60/40 or 50/50 rules are rejected by the IRS and increase your audit risk.

• A formal, reasonable compensation report and compliant payroll system are your best safeguards.

• The IRS is utilizing AI and data analytics to identify S corps with low salaries, thereby increasing the stakes for compliance.

• An S corp reasonable salary can be more than compliance—it’s a strategic benchmark for business growth.

Is There a Simple “Reasonable Salary” Formula?

Unfortunately, no single formula exists for tax purposes. The IRS intentionally leaves “reasonable compensation” undefined, requiring a facts and circumstances analysis unique to each business. While this creates flexibility, it also introduces risk.

Your salary should reflect the fair market value of the services you provide. An arbitrary rule of thumb—like paying yourself 60% of profits as salary and 40% as distributions—is not defensible. Instead, you’ll need a methodical approach supported by data.

Because this is a gray area, having personalized guidance from a CPA, EA, or tax professional who understands both your industry norms and state regulations can make the difference between a safe strategy and an audit red flag. Using 1-800Accountant’s business tax advisory service ensures your compensation plan is built on solid ground.

Methodologies for Determining and Defending Reasonable Salary

The Market Approach: What Would a Stranger Be Paid?

The market approach asks: What would another company pay someone with my skills to perform this role?

This is the preferred method by both the IRS and the courts. It involves gathering data from credible sources, such as the Bureau of Labor Statistics, industry salary surveys, and compensation reports.

For instance, if you operate an IT consulting firm and fulfill the duties of a senior consultant, you should research what similar roles pay in your region. That figure becomes your defensible salary baseline.

The Cost Approach: Evaluating Your Multiple Roles

Many small business owners wear multiple hats—CEO, CFO, salesperson, and HR manager all in one. The cost approach breaks down each role and assigns a fair salary to each.

Example:

• CEO duties: $60,000

• Sales manager duties: $40,000

• Bookkeeping support: $10,000

In this scenario, your total reasonable compensation would be $110,000. This approach is beneficial for solo entrepreneurs or small businesses where the owner carries most responsibilities.

The Income Approach: The Independent Investor Test

This method asks whether an outside investor would be satisfied with the company’s return after paying your salary. If your S corp nets $200,000 and you draw an $80,000 salary, would an investor consider the remaining $120,000 a reasonable return on their investment?

The income approach is less common but helpful in unique or highly profitable cases where salary data is harder to obtain.

Key Factors the IRS Examines

When evaluating reasonable compensation, the IRS looks at several factors that contribute to the "facts and circumstances" during an audit. 

Your Role and Responsibilities

Clearly documenting your job duties and decision-making authority is incredibly important. A well-written job description is your first line of defense.

Your Background and Experience

Education, certifications, and years of professional experience all justify higher compensation for your role. For example, a CPA with 15 years of experience should earn more than an accountant who just graduated from university.

Time, Effort, and Business Complexity

The more hours you dedicate and the more complex your business operations, the higher your salary should be. Other factors contribute, including: 

• Industry

• Company size

• Financial condition

Accurate Bookkeeping Can Justify Compensation

Without accurate financial records, you cannot adequately demonstrate these factors.

That’s why affordable, full-service bookkeeping from 1-800Accountant is essential for ensuring your compensation analysis withstands IRS scrutiny.

Audit Risks of 60/40 and 50/50 Rules

Some business owners follow “rules of thumb,” like splitting salary and distributions 60/40 or 50/50. While simple, these approaches lack defensible data. The IRS and tax courts consistently reject them, viewing them as arbitrary.

If audited, these shortcuts are red flags. Instead, anchor your compensation in market-based analysis and proper documentation. This ensures accuracy and the best defense against the IRS. 

Building an Audit-Proof Foundation: Documentation and Payroll

Creating Your Reasonable Compensation Report

A clear job description, documented market research, the chosen methodology, and minutes from board meetings where the salary was approved are essential components of a formal, reasonable compensation analysis.

Your report should include:

• Job title

• Time allocation per role (full-time or part-time)

• Market salary data per role

• Calculation summary

• Board meeting notes or internal memo approving salary

This is not busywork—it’s a risk management strategy that protects you from back taxes, penalties, and interest.

Integrating Salary into a Compliant Payroll System

Once determined, your salary must be processed through a payroll system that includes withholdings for FICA/Social Security and Medicare taxes.

Using 1-800Accountant's full-service payroll solution handles filings on your behalf and ensures compliance across federal and state requirements.

Increased IRS Enforcement: How to Prepare for the Rise of AI-Powered Audits

The IRS is now using data analytics and AI to identify S corps that report unusually low salaries alongside high distributions. This modern enforcement approach increases audit risk for non-compliant businesses.

Proactive documentation and expert support are critical in this new normal. With affordable, year-round small business tax advisory from 1-800Accountant, you gain a team that can guide you through the process and prepare defense documents, ensuring your taxpayer rights are respected. 

From Compliance to Strategy with 1-800Accountant

Balancing S corp tax benefits with the complex and high-stakes requirement of reasonable compensation is a challenge. Reasonable compensation is not just about avoiding audits—it’s a strategic tool for managing growth. Reasonable compensation is not a "set it and forget it" calculation, either. Instead, reviewing your salary annually provides valuable insights into the real value of your labor, which helps inform pricing, hiring decisions, and long-term tax planning.

By integrating bookkeeping, payroll, tax advisory, and entity strategy, 1-800Accountant, America's leading virtual accounting firm, creates a seamless ecosystem for you as a new S corp owner. With expert CPAs, EAs, bookkeepers, and tax professionals guiding you year-round, your compensation strategy stays optimized as your business evolves.

Don't wait for an IRS notice – schedule a free 30-minute consultation today to discuss a defensible, audit-ready compensation plan for your S corp.

Reasonable Compensation FAQs for S Corporations

What is compensatory intent?

Compensatory intent is the IRS requirement that payments classified as wages must genuinely be intended as compensation for services rendered—not disguised distributions.

How can I demonstrate compensatory intent?

Use payroll records, job descriptions, and board meeting minutes to prove wages were designated and paid as salary. This is a great way to demonstrate your compensatory intent. 

How can previous non-compliance be rectified?

File amended income tax returns, correct payroll filings, and adjust current-year compensation to rectify previous issues with non-compliance. Engaging a CPA helps reduce potential penalties.

What is the difference between distribution and reasonable compensation?

Compensation is subject to payroll taxes, whereas distributions are not, resulting in substantial tax savings. However, distributions can only occur after a reasonable salary is paid.

How do bonuses figure into reasonable compensation for S Corps?

Bonuses count toward compensation, but base salary must still reflect fair market value. A bonus should supplement—not replace—a reasonable salary.

What are IRS penalties for being in non-compliance?

Penalties for non-compliance can be substantial. They can reclassify distributions as wages subject to federal income tax, back taxes, interest, and potential 20–40% penalties. These penalties are on top of the stress you'll experience as your operations are disrupted. 

Is the owner’s draw the same as reasonable compensation for S Corps?

No. An owner’s draw is a distribution, not wages. To qualify, compensation must run through payroll with business income tax withholdings.

How do I figure out if my current salary is too low?

Compare your role, time commitment, and responsibilities against credible salary data to determine if your salary is too low or high. If your pay is less than 30–40% of the business's net income, your risk of an IRS audit typically increases.

Can I adjust my reasonable salary mid-year?

Yes, you can make adjustments to your reasonable salary in the middle of the year. Document the change with updated job descriptions, financial data, and board approval to maintain defensibility.

What if I didn’t pay myself at all last year?

If you didn't pay yourself at all, you may face IRS penalties if audited. Correct the issue by implementing a payroll system immediately and consulting a CPA to amend prior filings to avoid potential court cases. Proactively address problems rather than waiting for the IRS to discover them.