What Is a Reasonable Salary for an S Corp Owner?

A reasonable salary is the W-2 wage an S corporation must pay a shareholder who works in the business, set at roughly what the company would pay someone else for the same services. The IRS requires it before profits are taken as distributions, and it can reclassify distributions as wages, with payroll taxes due, if the salary is too low.

Why does the IRS require a reasonable salary?

Because otherwise every S corp owner would pay themselves $0 in wages and take all profit as distributions, which aren't subject to employment taxes. The IRS's position is direct: "S corporations must pay reasonable compensation to a shareholder-employee" in return for services before non-wage distributions may be made. The salary goes through payroll like any employee's, with Social Security and Medicare on both sides. If the IRS decides a distribution was really pay for your work, it can reclassify it as wages, and employment taxes become due on it.

This only applies if you've elected S corp status. Sole proprietors and default LLCs don't take a salary; they pay self-employment tax on all net profit. See S corp vs. LLC for that decision.

How do you figure a reasonable salary?

Start with what you actually do, not with the tax savings you want. The IRS lists factors courts have used to decide reasonable compensation:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

The IRS also describes a way to think about where the profit comes from. Money that comes from the owner's personal services should be treated as wages. Money that comes from other employees' work and from the company's equipment and capital can be treated as distributions. A one-truck owner-operator earns nearly all the profit with their own hands; a shop owner with eight techs earns much of it through the crew and the trucks.

1. 1

   List the roles you fill.

   Most trades owners wear several hats: lead tech, estimator, dispatcher, operations manager, bookkeeper. Estimate hours per week in each.

2. 2

   Price each role at market pay.

   Use what you pay your own employees for similar work and published wage data, such as Bureau of Labor Statistics occupational wage estimates for your area, for roles like HVAC mechanic, plumber, construction manager or bookkeeper.

3. 3

   Weight by time.

   Combine the role pay rates by the share of time you spend in each. That's the starting point for your salary.

4. 4

   Sanity-check against the business.

   Is your salary below what you pay your best tech, for more responsibility? That's hard to defend. Is it more than the business can sustain in a slow year? Adjust and document why.

5. 5

   Write it down and revisit yearly.

   Keep the worksheet, the wage data you used and board or owner minutes setting the salary. Change it when your role or the business changes.

Is there a rule like 60/40 for S corp salary?

No. You'll hear "60/40" or "one-third salary" rules of thumb online, but the IRS doesn't publish a percentage. Its factor list includes "the use of a formula to determine compensation" as one thing courts look at, which means a formula is evidence, not a safe harbor. A ratio that ignores what you actually do and what the market pays for it is weak support. Base the number on the factors and keep the documentation.

Reasonable salary by trade

Reasonable salary and the QBI deduction

Your S corp wages are not qualified business income. The QBI deduction is figured on the profit that flows through after your salary, and the IRS Form 8995 instructions list reasonable compensation from an S corporation among the items excluded from QBI. A higher salary means more payroll tax and a smaller QBI base. At higher incomes, though, the W-2 wages the business pays (including yours) can help you get past the QBI deduction's wage limitation. That trade-off is exactly the kind of calculation to run with a CPA.

What about health insurance for an S corp owner?

If you own more than 2% of the S corporation, the IRS says health insurance premiums the company pays for you are deductible by the company and reported as wages on your W-2. Those amounts are subject to income tax withholding but not Social Security, Medicare or FUTA tax when the plan covers all employees or a class of them. You may then be able to take the self-employed health insurance deduction on your own return if the requirements are met. Get the payroll setup right with your CPA.

Common mistakes

• No salary at all. Taking only distributions while working full time is the textbook audit issue.
• Paying yourself less than your employees. Hard to defend when you do the same work plus run the company.
• Paying salary irregularly. Run it through payroll on a schedule, with withholding and deposits, not as a lump at year end.
• Picking a percentage off the internet. There's no IRS ratio.
• Not documenting. If you can't show how you set it, the IRS picks the number for you.