S-Corp Reasonable Compensation – The Wealthy Accountant

Small business owners often consider the S-corporation to reduce payroll taxes on owner’s profits and to efficiently manage their business.

Avoiding the payroll tax on all owner’s profits is a main inducement for becoming an S-corp. As long as the owner receives reasonable compensation there are no problems. There is even an opportunity to not pay reasonable compensation for some years without issue. More on this later.

Since all owner’s profits in excess of their payroll flow to the personal tax return via the K-1, and all profits from the K-1 avoid the payroll tax (Social Security and Medicare), owners quickly realize they want their wages/salary to be as low as possible. Why not even zero?

The IRS knows this trick and therefore requires reasonable compensation to shareholder-employees of S-corporations (Regs. Sec. 31.3121(d)-1(b)). Reasonable compensation extends to family members (IRC Sec. 1366(e)) as well to prevent income shifting or similar strategies to avoid payroll taxes.

Let’s dispel the many S-corp reasonable compensation myths before we determine how to calculate reasonable compensation.

Reasonable Compensation Myths

Since the legal avoidance of payroll taxes is a prime motivator for organizing an S-corporation, many myths have formed over the years to enhance the avoidance of these payroll taxes. They are myths because they will not pass IRS scrutiny.

1. Reasonable compensation to shareholder-employees is not required. Many years ago the S-corp tax form (1120-S) did not break out shareholder and non-shareholder wages. The IRS had difficulty determining how much in wages belonged to shareholder-employees unless they also reviewed payroll records.

   That has now changed. Wages/salary are broken down between shareholders and non-shareholders. The IRS now has it easy in identifying reasonable compensation to owners, or non-reasonable compensation.

2. A $10,000 salary satisfies the IRS reasonable compensation rules. This was never a guideline or rule issued by the IRS, the Tax Court, or in regulations. There was a time when the IRS struggled defining reasonable compensation. Many myths developed during those years. Some people noticed the IRS didn’t challenge tax returns with at least some compensation to shareholder-employees.

   I don’t know how much the IRS challenged such positions. It is important to note that $10,000 is not a cap on reasonable compensation. In fact, a $10,000 salary has nothing whatsoever to do with reasonable compensation to shareholders.

3. The Social Security wage base is a safe harbor. It’s not! While the Social Security wage base ($176,100 in 2025) is much higher than the $10,000 myth, it is still not a rule or guideline. It is true the IRS will challenge few, if any, wages/salaries at the Social Security wage base for shareholder-employees.

   It is important to note that the Social Security wage base is not reasonable compensation because it might encourage the business owner to over-compensate her wage/salary over fear of IRS scrutiny. Reasonable compensation is not under- or over-compensation. Both harm the taxpayer. Excess compensation to the shareholder-employee can cause a lost deduction on the excess salary.

4. The 60/40 and 50/50 rule. The 60/40 and 50/50 rule is based off a percentage of profits. With this rule the owner takes either 50% or 60% of profits as a salary, depending on the rule in question.

   Inside the tax profession many professionals use one of these rules or something similar. ADP, the largest payroll processor in the U.S., mentions the 60/40 rule where 60% of profits before the owner’s salary is used as reasonable compensation. Then a disclaimer is given: Although many accountants use the 60/40 rule of thumb, it’s not officially approved by the IRS.

   Many tax professionals may start with 50% or 60% of profits before the owner’s wages or salary as a starting point, but reasonable compensation is more involved than a simple percentage rule.

5. $5,000 per month is reasonable compensation per IRS guidelines. I bring this one up since it is making the rounds on social media recently (see image below).

   There is no guideline that says ~$5,000 per month is reasonable compensation for an owner-employee. As a tax professional I may consider the 60/40 rule as a starting point. There is nothing, however, about $5,000 per month that indicates reasonable compensation.

Of course, there are other reasonable compensation myths out there. Rather than get bogged down on these unacceptable shortcuts, let’s look at how to calculate reasonable compensation the IRS will accept.

Calculating Reasonable Compensation

First, some ground rules.

If the IRS challenges the reasonable compensation of an S-corporation, the burden of proof falls on the S-corporation. (Long Island Drug Co., Inc. v. Commissioner, 111 F.2d 593 (2nd Cir. 1940))

Remember the myth above where you take the Social Security wage base as reasonable compensation? The reason this is a bad idea is that it can lead to excessive compensation. Due to the structure of the tax code, C-corporations, also known as regular corporations, are often tempted to issue excessive compensation to insiders. (Treasury Regulation 1.162-8) Section 1.162-8 is not limited to regular corporations. it can also apply to S-corporations. In the case of excessive compensation, only the reasonable portion is deductible by the S-corporations. Yet, the owner has a W-2 with 100% of the compensation paid. For this reason, calling all profits owner’s wages is not a defensible position.

Reasonable compensation was first outlined on November 17, 1947 in the Mayson Manufacturing Co. v Commissioner decision.

Later, the Tax Court (Pulsar Components International, Inc. v. Commissioner, T.C. Memo 1996-129) provided factors to be used in determining reasonable compensation. These factors include:

1. The employee’s qualifications
2. The nature, extent, and scope of the employee’s work
3. The size and complexities of the employer’s business
4. A comparison of salaries paid with the employer’s gross and net income
5. The prevailing general economic conditions
6. A comparison of salaries with distributions to officers and retained earnings
7. The prevailing rates of compensation for comparable positions in comparable concerns
8. The salary policy of the employer as to all employees
9. The amount of compensation paid to the particular employee in previous years
10. The employer’s financial condition
11. Whether the employer and employee dealt at arm’s length
12. Whether the employee guaranteed the employer’s debt
13. Whether the employer offered a pension plan or profit-sharing plan to its employees
14. Whether the employee was reimbursed by the employer for business expenses that the employee paid personally

You might notice Factor #4 mentions salaries based on gross and net income. Sounds a lot like the 60/40 and 50/50 rules. However, it must be noted that no single factor prevails. The facts and circumstances that consider all 14 factors that apply are required in determining reasonable compensation.

So, how can an S-corporation use the above factors in determining reasonable compensation? The easiest solution is to use an online salary guide. Robert Half has a salary calculator, along with a salary guide.

Once you determine reasonable compensation in your industry you will need to make adjustments for Factors #10-#14 above, since these are specific to the employer.

You can also hire firms like RC Reports to help you develop a reasonable compensation plan for shareholder-employees.

Reasonable compensation comes down to common sense. What would a reasonable person accept as a salary in a similar situation? The difficult part is removing the personal aspect in the relationship between owner and business where S-corp owners are involved.

Reasonable compensation is a wide road. Factors, such as the companies financial condition, play a role. Still, steps are easily taken to pass the reasonable compensation requirements for S-corporations.

The IRS defines reasonable compensation as:
“The value that would ordinarily be paid for like services by like enterprises under like circumstances.”

Catching Up Missed Reasonable Compensation

What if the S-corporation missed past reasonable compensation to shareholder-employees? What if the S-corporation lacks funds to make reasonable compensation to a shareholder-employee?

The good news is that not paying reasonable compensation in the current or prior years is not fatal.

Why? Because IRS guidelines on reasonable compensation say this:
Reasonable compensation can never exceed the amount received by the shareholder directly or indirectly. Profit and loss is not mentioned; instead, “amount received” is. What is of concern is if the S corporation owner is taking a distribution or other item of value from the S corporation.

This means that as long as the owner-employee of an S-corporation take a reasonable compensation before any distributions are paid there are no consequences from the IRS. Remember, all reasonable compensation missed from prior years must be paid to the owner-employee before a distribution is made!

And that leads to a strategy.

An shareholder-employee of an S-corporation can refuse all compensation for any reason. As long as reasonable compensation from all years missed are caught up before a distribution is made there are no penalties.

What if you take a distribution before reasonable compensation is made? In such a situation the IRS would likely recharacterize distributions as wages. This would have a limited effect on the income tax portion of the shareholder-employee’s tax return. But, the payroll tax on the recharacterized distribution, including penalties and interest, could be significant.

The S-corporation offers tax savings opportunities for the business owner. However, the S-corporation is much more complex than a sole proprietorship that reports income and expenses on Schedule C of the personal tax return.

S-corporation shareholder-employees are required to take reasonable compensation. Some owners may take no compensation because they are not involved in the business. However, at least one individual will play a role in the management and operations of the company. Any individual working for an S-corporation where more than 2% of shares are owned must follow reasonable compensation rules. The same applies to family members of shareholders.

For whatever reason, the owner-employee can refuse reasonable compensation as long as no distribution is received. All prior reasonable compensation missed must be caught up before a distribution is made.

And that is how you calculate a reasonable wage or salary for a shareholder-employee of an S-corporation.