One of the most common challenges for S-Corporation (S-Corp) owners is deciding how much salary to pay themselves.
While setting a lower salary may seem like a way to reduce tax liability, doing so incorrectly can significantly increase the risk of an IRS audit.
In this article, from the perspective of a CPA, we’ll explain the concept of “Reasonable Compensation” and provide practical insights on how to determine an appropriate salary level for S-Corp owners.
What Happens If Your Salary Is Too Low
In an S-Corporation, the owner serves as both a shareholder and an employee, paying themselves a salary.
This salary portion is subject to Social Security tax and Medicare tax, while distributions are not subject to these employment taxes.
Because of this, it is common for some S-Corp owners to set their salary extremely low and take the rest as distributions in an effort to minimize taxes.
However, the IRS requires that owners who are actively involved in running the business receive “reasonable compensation.”
If the IRS determines that the salary is unreasonably low, it may reclassify part or all of the distributions as wages, resulting in additional employment taxes, penalties, and interest.
Criteria for Determining Reasonable Compensation
When determining what qualifies as reasonable compensation, the IRS considers several key factors, including:
- Nature of duties and level of responsibility
— How much would an employee performing similar duties in a company of comparable size and industry typically earn? - Business performance and profitability
— If the company is generating healthy profits but paying an unusually low salary, it may draw IRS attention. - Time commitment and role distribution
— When there are multiple shareholders or officers, salaries should reflect each person’s actual contribution and the proportion of time devoted to the business. - Local wage levels
— Regional and industry-specific wage data, such as those published by the Bureau of Labor Statistics (BLS), can serve as a useful reference point.
Taken together, a practical benchmark is to ask:
“If the owner were hired by another company to perform the same work, what would be a fair market salary?”
Common Misconceptions and Mistakes
“My profit is small, so I set my salary at only $10,000.”
→ If your salary is too low, the IRS may determine that you are not actually taking a reasonable wage for the work performed.
“It’s fine because my accountant told me this amount.”
→ Unless there is clear justification showing that the salary amount is reasonable, the IRS may not accept it as valid.
“Other S-Corp owners are doing the same thing.”
→ The appropriate salary amount varies greatly depending on your industry, business size, role, and profit structure.
Practical Steps Recommended by CPAs
1. Refer to a Reasonable Compensation Study
Using industry-specific compensation data helps establish a clear and defensible basis for your salary level.
2. Review your salary annually based on business performance
If profits increase but your salary remains unchanged, the IRS may question the reasonableness of your compensation in future years.
3. Keep documentation showing the balance between salary and distributions
Maintain records explaining how your salary amount was determined, along with comparison data for other officers.
This documentation can serve as important evidence during an IRS audit.
Conclusion: Salary Setting Is Risk Management, Not Just Tax Saving
Setting your own salary as an S-Corp owner is not merely a tax-saving strategy, but an essential part of risk management.
Establishing an appropriate compensation level helps prevent IRS audits and also affects your future Social Security benefits.
Reducing your salary too aggressively may lower your long-term Social Security payout — a risk that should not be overlooked.
If you’re uncertain whether your current salary level is appropriate, it’s wise to review it from both tax and accounting perspectives.
At Hiromi K. Stanfield, CPA Inc., we provide consultations for S-Corp owners on salary optimization and distribution strategies to ensure compliance and long-term financial stability.
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