S-Corp Reasonable Salary: How Much Should You Pay Yourself?

Every S-corp owner eventually asks the same question, usually right after the first year's tax return shows how much the election saved: how low can the salary go? The practitioner's answer is that the salary is not a number you pick to minimize tax. It is a number you have to be able to defend, with evidence, as what the business would pay a stranger to do your job.

Get it right and the S-corp election does what you hoped. Get it wrong in either direction and you are overpaying payroll tax every year or carrying an audit exposure that grows with every distribution. Here is what the IRS looks at, why the popular shortcuts fail, and how we build a number that holds up.

What the IRS actually looks at

The rule itself is short. An S-corp must pay reasonable compensation to a shareholder-employee for the services they provide before it makes non-wage distributions, and distributions to an officer are treated as wages to the extent they represent reasonable compensation for services. The IRS spelled out the factors in its 2008 fact sheet, FS-2008-25, Wage Compensation for S Corporation Officers, and they are the same factors the courts use:

• Your training and experience
• Your duties and responsibilities
• The time and effort you devote to the business
• Dividend (distribution) history
• What the company pays non-shareholder employees
• The timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements and any formula used to set pay

The IRS also frames the question in a way that is more useful than the list: where do the company's gross receipts come from? It names three sources: the shareholder's own services, the services of non-shareholder employees, and capital and equipment. Profit generated by your labor should be paid as wages. Profit generated by your staff, your trucks, your inventory or your invested capital can properly come out as distributions. A solo consultant with no employees and no equipment has little room to call anything a return on capital. A contractor with twelve field employees and $600,000 of equipment has a great deal.

The leading case is David E. Watson, P.C. v. United States (8th Cir. 2012). Watson, a CPA with roughly 20 years of experience, paid himself $24,000 a year while taking $203,651 and $175,470 in distributions in 2002 and 2003. The court accepted the IRS expert's replacement-cost analysis and set his wages at $91,044, then assessed the back employment taxes, penalties and interest. What sank him was not the low salary alone; it was that the number bore no relationship to what a comparable accountant earned.

Why the "60/40 rule" is a myth

You will read online that the IRS accepts a 60/40 split, salary to distributions, or sometimes 50/50. There is no such rule. It appears nowhere in the Internal Revenue Code, the regulations, FS-2008-25 or any court decision. It is a rule of thumb someone invented because it was easier than the real analysis, and it fails in both directions.

Take two businesses each netting $200,000 before owner pay. The first is a solo IT consultant billing her own hours. The second is a landscaping company with eight crew members, four trucks and an owner who spends most of his week selling and scheduling. A 60% salary ($120,000) is plausibly too low for the consultant, whose entire profit comes from her labor, and too high for the landscaping owner, whose profit comes mostly from his crew and equipment. The same percentage cannot be right for both, and a percentage ignores the factor the IRS weighs most heavily: what the job pays in the market.

How to build a number you can defend

The approach that holds up is the one the IRS expert used in Watson, and the one commercial tools such as RCReports have packaged: replacement cost. What would the company have to pay to hire someone to do everything you do?

Start by listing your roles and the share of your time each takes. Most owners wear three to five hats: technical work, sales and estimating, operations and staff management, bookkeeping and admin. Then price each role using published wage data. The most defensible public source is the Bureau of Labor Statistics Occupational Employment and Wage Statistics program, which publishes median and percentile wages for about 830 occupations nationally, by state and by metro area, including Tampa-St. Petersburg-Clearwater. The current release is for May 2025. Place yourself within the range based on experience: a 20-year master technician is not paid the median.

Weight each role's wage by the time you spend on it, add them up, and you have a replacement cost. Then check it against the other factors: is it in line with what you pay your best non-owner employee? Does the distribution history make sense against the capital and staff in the business? Write the analysis up in a one-page memo, date it, keep the wage printouts behind it, and record the salary in the corporate minutes. Revisit it every year or two, or whenever your role changes. That file turns "we thought $60,000 seemed fair" into a position an examiner can read.

Worked example: a Tampa HVAC company

An owner runs an HVAC company in Tampa with $1.1 million of revenue, six employees, and $210,000 of profit before her own pay. She spends about 55% of her time in the field as senior technician and estimator and 45% running the company: hiring, scheduling, pricing, vendors and reviewing the books.

She sets her salary at $97,000 and takes the remaining profit, after employer payroll taxes and the cost of running payroll, as distributions of roughly $105,000. Compare that with the two shortcuts. The "60/40 rule" would put her salary at $126,000, which costs an extra $29,000 of wages times 15.3%, or about $4,400 a year in Social Security and Medicare tax, for no reason other than a formula. A salary of $40,000, which we see often, saves about $8,700 a year in payroll tax but has no support anywhere in the wage data, and the gap between it and the defensible number is exactly what an examiner would reclassify.

Her business also has real non-owner sources of profit: six employees and a fleet. That supports the roughly 48/52 split between salary and distributions the analysis produced. A solo consultant netting the same $210,000 would end up with a much higher salary share, because almost all of the profit comes from her own hours.

How salary interacts with retirement contributions, health insurance and QBI

A low salary has costs beyond audit risk. Employer contributions to a SEP-IRA or solo 401(k) are limited to 25% of your W-2 compensation, with an overall cap of $72,000 for 2026. At a $97,000 salary, the HVAC owner can put in $24,500 of her own deferrals (the 2026 401(k) limit; $8,000 more if she is 50 or older) plus a $24,250 employer contribution, about $48,750 in total. At a $40,000 salary the employer piece falls to $10,000, and the retirement plan becomes the biggest thing she gave up to save payroll tax. Retirement limits are published each year in the IRS cost-of-living announcement.

Health insurance premiums the company pays for a more-than-2% shareholder are added to Box 1 of your W-2 (but not to Social Security and Medicare wages) and then deducted on your personal return as self-employed health insurance. They count as part of your compensation package when you look at whether total pay is reasonable.

The qualified business income deduction pulls the other way. Your W-2 salary is not QBI, so a higher salary shrinks the 20% deduction on the K-1 income. Below the 2026 thresholds ($201,750 single, $403,500 joint) that is a pure cost. Above them, the deduction is limited by W-2 wages the business pays, and your own salary counts, so a higher salary can preserve a deduction that would otherwise be lost. This is one of the reasons the salary decision belongs inside a full tax projection, not on its own.

What happens when salary is zero and distributions are large

An 1120-S with substantial profit, large distributions and $0 on line 7 (compensation of officers) is the most visible mismatch on the form, and it is the pattern the IRS built its reasonable-compensation enforcement around. If the return is examined, the agent reclassifies enough of the distributions to bring wages up to a reasonable figure and assesses the results: 15.3% in Social Security and Medicare tax on the reclassified amount, failure-to-deposit penalties that run from 2% to 15% because the payroll taxes were never deposited, penalties for the missing W-2s and 941s, a possible 20% accuracy-related penalty on any resulting income-tax underpayment, and interest, currently 7% a year compounded daily. Multiply by three open years.

Using the HVAC owner's numbers, reclassifying $57,000 of distributions (from $40,000 to $97,000 of salary) means about $8,700 of employment tax per year before penalties and interest. Over three years the bill approaches $30,000 plus professional fees, against savings that were never really yours.

Common mistakes

The mistakes we see most: paying no salary in year one "because cash was tight" while still taking draws; setting the salary once at the election and never revisiting it as profit tripled; using a percentage with no wage data behind it; paying the owner less than the best-paid employee doing similar work; and running the salary as a single December payroll, which is legal but reads as an afterthought. The fix for all of them is the same file: a dated memo, comparable wage data, and a salary that moves when the business does.

When to get help

Setting a reasonable salary is a small piece of work with a large tail. We build the replacement-cost analysis, tie it to the retirement, health insurance and QBI decisions in the same projection, document it, and run the payroll so line 7 matches the memo in the file. That is part of our business tax planning and preparation service, with payroll and W-2 support handling the monthly mechanics.

If you have an S-corp and cannot point to a document that explains your salary, or you have not run payroll at all this year, there is still time to fix it before December 31. Request a 20-minute fit call and we will tell you whether your current number is defensible and what it would take to make it so. For the broader comparison of structures, start with LLC vs. S-corp: how the taxes actually differ.

Jenny Gao, CPA, EA

Founder of Balance Partners. Florida-licensed CPA and IRS Enrolled Agent with more than a decade of accounting and tax experience. Jenny writes and reviews every guide on this site. About Jenny

This article is general educational information for U.S. business owners and is not accounting, tax, legal, payroll or financial advice for your situation. Rules change and vary by entity, state and facts. Balance Partners, LLC does not provide audit, review or other attest services. Last reviewed September 14, 2026.