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What You Need to Pay Yourself and What Happens If You Don't
You've just elected S-Corp status for your business, and you're excited about the potential tax savings. But then, your accountant mentioned something about "reasonable compensation," and you're wondering:
"What if I just pay myself $1 in salary and take everything else as distributions? Wouldn't that maximize my tax savings?"
Here's the problem with that: The IRS thought of this decades ago, and they have rules specifically designed to prevent it.
Getting your reasonable compensation wrong can trigger an audit, lead to back taxes and penalties, and eliminate the very tax savings you were hoping to gain.
At Patrick Accounting, we help S-Corp owners understand these requirements every day. The goal isn't to pay more than you need to. It's to pay the right amount based on defensible criteria that will stand up to IRS scrutiny.
In this article, we'll break down:
- What reasonable compensation actually means
- How to calculate it for your unique situation
- What happens if you get it wrong
- How to stay compliant and still benefit from the S-Corp tax advantage
What "Reasonable Compensation" Really Means
If you're an S-Corp shareholder who performs services for the business, the IRS requires you to pay yourself a reasonable salary before taking any profit distributions. This isn't optional. It's a legal requirement.
Why? Because the IRS doesn't want you paying yourself an artificially low salary to avoid Social Security and Medicare taxes. Think about it: Without this rule, every S-Corp owner would pay themselves $1 and take everything else as distributions.
The IRS defines reasonable compensation as the amount "that would ordinarily be paid for like services by like enterprises under like circumstances."
In plain English: What would you have to pay someone else to do your job?
How to Calculate Your Reasonable Salary
There's no magic number, but the IRS has established specific factors that courts use to evaluate whether compensation is appropriate:
1. Comparable Pay for Your Role
Research what similar businesses pay for similar roles in your geographic area. Use:
- Salary surveys
- Job posting websites
- Bureau of Labor Statistics
data
2. Time Spent Working in the Business
- If you're working full-time (or overtime), your compensation should reflect that.
- If you're only involved part-time or in an advisory role, a lower salary may be appropriate.
3. Your Skills, Education, and Experience
- Owners with specialized expertise, an MBA, or decades of experience can justify higher pay.
- Less experienced owners may warrant a lower starting salary.
4. The Profitability and Stage of Your Business
- If your business just became profitable, your salary can be modest.
- If it's consistently generating strong income, your salary should grow accordingly.
Consider this example:
In year one, your business lost money. In year two, you made $20,000. In year three, you made $100,000 profit.Your reasonable compensation for year three doesn't automatically jump to $100,000. At the beginning of the year, you didn't know you'd be that profitable, so you might set your salary at $48,000 based on prior performance and take the remaining $52,000 as distributions.
However, if you consistently make $100,000+ year after year, your reasonable compensation should increase to reflect ongoing profitability.
Real Examples of Setting Salary vs. Distributions
Let's walk through some practical scenarios to show how reasonable compensation works in different business situations. These examples will help you understand how to apply the IRS factors to your specific circumstances.
How Reasonable Compensation Works in a Solo Service Business
If you're a consultant generating $150,000 annually and you're the only person providing services, it would be difficult to justify a large gap between salary and distributions. Since you're personally performing billable work, most of your compensation should be salary.
Reasonable approach:
- Setting your salary at $120,000
- Taking $30,000 in distributions
But a $50,000 salary with $100,000 in distributions? That would likely raise red flags.
How Reasonable Compensation Works in a Multi-Employee Business
If you run a small agency with several employees and spend your time focused on strategy and management rather than day-to-day client work, a larger gap might be justifiable. You're wearing multiple hats: employee (management work) and owner (providing capital and taking business risk).
Reasonable approach:
- Setting your salary at $75,000 for your management role
- Taking $75,000 in distributions for your ownership risk.
Because your work is more strategic and less tied to daily revenue generation, 50/50 split may be defensible.
What Happens When You Get Reasonable Compensation Wrong?
The consequences of underpaying yourself can be severe and expensive. Here's what you're risking if you try to minimize your salary below reasonable levels.
IRS Audit Red Flags
The IRS flags returns with:
- Salary significantly below industry averages
- Large distributions with minimal salary
- No salary payments despite active business involvement
Financial Consequences
When the IRS determines your compensation was unreasonably low, they'll reclassify distributions as wages, creating:
- Back payroll taxes: You'll owe Social Security and Medicare taxes on reclassified wages (both employee and employer portions: 15.3% total).
- Penalties and interest: These are applied from the original filing dates, which adds up quickly over multiple years.
Example: If the IRS reclassifies $40,000 of distributions as wages, you'll owe approximately $6,120 in additional payroll taxes, plus penalties and interest, with no additional deductions to offset this cost.
What Are the Realistic Tax Savings from an S-Corp?
S-Corp status can save you money, but not by gaming the system.
Let's look at some actual numbers:
Say your business generates $100,000, and you set your reasonable compensation at $60,000.
- As an LLC: You'd pay self-employment tax of approximately $15,300 on the full $100,000.
- As an S-Corp: You'd pay payroll taxes of approximately $9,180 on the $60,000 salary.
Your estimated tax savings would be about $6,120. That's meaningful, but it's not the dramatic "pay nothing in taxes" myth that gets passed around on social media.
When Reasonable Compensation Gets Complicated
Some business situations make reasonable compensation calculations more complex than the standard examples. Here are common scenarios that require extra attention and careful planning.
- Multiple owners: Each owner's compensation should reflect their actual role and time in the business.
- Seasonal businesses: Set a reasonable salary based on expected annual income, but document your process and adjust when appropriate.
- New businesses: Start with conservative estimates based on industry data and projections, and then adjust and refine over time with real data.
How to Document Your Compensation Decision
Proper documentation is your best defense if the IRS questions your reasonable compensation.
Research and save documentation from:
- Bureau of Labor Statistics wage data
- Industry salary surveys
- Online salary databases
- Local employment data
- Job descriptions for your role(s)
- Time estimates of hours worked
- Corporate minutes/resolutions on compensation
- Annual reviews and adjustments
- Business performance data supporting compensation levels
Being proactive with documentation makes your compensation defensible if ever challenged.
Getting Reasonable Compensation Right
Reasonable compensation isn't about paying as little as possible. You want to pay an appropriate amount that reflects the value of services provided while optimizing your tax situation.
Here are the key principles:
- Base compensation on what you'd pay someone else to do your job.
- Document your research and decision-making process.
- Review and adjust as your business evolves.
- Focus on compliance first, tax savings second.
The few thousand dollars in extra tax savings from an unreasonably low salary aren't worth the risk of IRS audits, penalties, and the stress of tax problems.
At Patrick Accounting, we help business owners like you find that balance, so you get the benefit of the S-Corp election without the compliance headaches.
Ready to optimize your S-Corp strategy?
If you're wondering how much you should pay yourself, or you want a second opinion on your current structure, we can help.
Looking for more information on whether an LLC or S-Corp structure is best for your business?
