An S-corp owner who works in the business must be paid a salary before taking distributions. The IRS calls it reasonable compensation and it is the single most litigated S-corp issue, because every dollar moved from salary to distribution saves about fifteen cents of payroll tax. The temptation is obvious. So is the audit trail.
What reasonable means
What the business would pay an unrelated person to do the same work, with the same skills, for the same hours, in the same place. Not a percentage of profit, not a rule of thumb, and not the minimum that makes the numbers work. Courts have looked at training, duties, time spent, what comparable businesses pay, and what the owner paid non-owner staff for similar roles.
The patterns that get audited
- Zero salary with large distributions: the case the IRS wins every time.
- A salary far below the market rate for the role, in a profitable business.
- Officer compensation on the 1120-S out of line with the business's size and the owner's evident involvement.
- Distributions taken monthly like a salary while the W-2 shows a token amount.
Nobody sets out to cheat here. Most low salaries come from a preparer's suggestion years ago that was never revisited as the business grew.
A method that holds up
- List what you actually do. Sales, delivery, management, admin, with rough hours per week for each.
- Price each role. Salary surveys, job postings in your area, what you pay or would pay staff. Weight by hours.
- Adjust for reality. Part-time involvement, a business that cannot afford market rate yet, a year of losses. A struggling business can pay less; a profitable one cannot pay nothing.
- Write it down. One page, dated, with the sources. Put it in the permanent file. Repeat annually.
- Run it through payroll with proper withholding and a W-2, and keep distributions clearly separate in the books.
What it does to the saving
An honest salary reduces the S-corp saving, sometimes to nothing in a business with modest profit. That is the point at which the election should be reconsidered rather than the salary lowered. Run the numbers each year as the business changes.
If you have been underpaying
Fix it prospectively: set a defensible salary from this payroll onward, document the reasoning, and do not draw attention to prior years by changing them retroactively unless advised to. Most audits look at the most recent years; a current, documented salary is the best evidence that the earlier number was an error rather than a strategy.
The check: what did you pay yourself as salary last year, and what would you have to pay someone to replace you? If the second number is materially higher, the salary needs a new look.