The S-Corp Owner’s Guide to Reasonable Compensation

If you operate as an S Corporation, reasonable compensation is not optional, it’s a legal requirement.

Here’s what every S-Corp shareholder-employee needs to know:

• You must pay yourself a reasonable salary (via W-2) before taking any shareholder distributions.

• The IRS requires a Reasonable Compensation analysis each year using one of three approved approaches.

• You should maintain documentation supporting how your salary was determined annually.

S Corporations offer powerful tax advantages, but they also come with additional obligations, including:

• Paying shareholder-employees reasonable wages via payroll

• Filing a separate business tax return each year (Form 1120-S)

• Potential state-level fees or minimum taxes for S Corporations

• Possible filing or compliance costs when electing S-Corp status

If you’re unsure whether an S-Corp is the right structure for your business, an Entity Planning Analysis can help you evaluate tax savings, compliance requirements, and long-term financial impacts.

What Is Reasonable Compensation?

This is the single biggest area of confusion for S-Corp owners — and one of the IRS’s favorite audit targets.

The IRS defines Reasonable Compensation as:

“The value that would ordinarily be paid for like services by like enterprises under like circumstances.”
— IRC §162-7(b)(3)

In simpler terms:

What would you have to pay someone else to do the job you do, at a similar company, under normal market conditions?

A few essential reminders:

• Reasonable Compensation is based on the value of the services you provide, not business profit.

• Your salary must be paid through W-2 payroll before you take distributions.

• You can take wages without any distributions — but you cannot take distributions without wages.

• If you’ve underpaid yourself in prior years, you may “catch up” by adjusting compensation going forward.

How Do You Calculate Reasonable Compensation?

The IRS recognizes three primary methods for determining Reasonable Compensation:

1. Cost Approach
   Breaks down the owner’s job into tasks and assigns a market rate to each duty.

2. Market Approach
   Compares compensation to industry peers performing similar roles.

3. Income Approach
   Looks at company profits and isolates the portion attributable to the owner’s labor.

Each method is appropriate in different situations, and your accounting professional can help determine the most defensible approach based on your role, industry, and business model.

Best Practices When Determining Reasonable Compensation

• Update your analysis every year
  Roles evolve, markets shift, and wages change. Your salary should too.

• Document everything
  Keep sources, worksheets, salary studies, and calculations. Proper documentation is your best defense during an audit.

• Use unbiased, reliable data
  The IRS prefers data from objective sources such as the Bureau of Labor Statistics — not self-reported salary websites like Glassdoor or Payscale.

What Happens If I Don’t Take Reasonable Compensation?

Failing to take a reasonable salary — while taking distributions — exposes you to serious financial consequences:

• Back payroll taxes (FICA, FUTA, withholding)

• Failure-to-deposit and accuracy-related penalties

• Interest charges

• Potential revocation of your S-Corp status

• Possible preparer penalties assessed against your tax professional

If you're unsure whether your current salary meets IRS standards, now is the perfect time to review it. Hiatt Accounting Group offers formal Reasonable Compensation Studies to protect you from penalties and optimize your tax strategy. Reach out today to schedule your analysis.

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Email: ahiatt@hiattaccountinggroup.com
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