Reasonable Salary (S-Corp)
A reasonable salary is the fair market compensation an S-Corp owner must pay themselves for services performed, as required by the IRS before taking tax-advantaged distributions.
When you operate as an S-Corp, you're both an owner and an employee. The IRS requires that you pay yourself a "reasonable salary" for the services you provide to the business before taking any distributions. This salary is subject to payroll taxes (FICA).
There is no fixed formula for determining a reasonable salary. The IRS considers factors including: the type of work performed, training and experience, comparable salaries in similar industries, time devoted to the business, and the company's revenue and profitability.
Setting your salary too low is one of the most common S-Corp audit triggers. The IRS has successfully challenged salaries as low as $0 and won cases where owners took large distributions with minimal salary. As a rule of thumb, salary should typically be 40-60% of business net income, though this varies widely by industry.
The balance between salary and distributions is where the tax savings occur. Only the salary portion is subject to the 15.3% payroll tax, while distributions avoid this tax entirely. However, the savings only work if the salary is defensible.
Documenting how you arrived at your salary figure is crucial. Many business owners use compensation surveys, job posting data, or comparisons with industry benchmarks to support their salary level.
Practical Example
A marketing agency owner's S-Corp earns $300,000. She pays herself $110,000 (comparable to agency directors in her market) and takes $190,000 as distributions. The payroll tax savings on the $190,000 in distributions is approximately $29,070 compared to paying SE tax on the full amount.