Reasonable compensation requires S-corp owner-employees to pay themselves a fair market salary subject to payroll taxes before taking tax-advantaged distributions.
Why reasonable compensation matters for S-corp owners
S-corporation owners who work in their business must pay themselves a reasonable salary as W-2 wages before taking additional income as distributions. This requirement exists because S-corp distributions are not subject to self-employment or FICA taxes, while W-2 wages are. Without the reasonable compensation rule, owner-employees could take all business income as distributions and pay no payroll taxes.
Treasury Regulation 1.162-7(b)(3) describes reasonable compensation as the amount that "would ordinarily be paid for like services by like enterprises under like circumstances." IRS Fact Sheet FS-2008-25 adds that the Code and regulations give no specific guidelines, and lists the factors courts consider: training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, payments to non-shareholder employees, compensation agreements, use of a formula to set pay, and what comparable businesses pay for similar services.
There is no specific dollar threshold the IRS uses. The standard is fact-based. Courts have recharacterized distributions as wages when S-corp owners who ran the business took zero or minimal salary (Glass Blocks Unlimited v. Commissioner, T.C. Memo. 2013-180; Sean McAlary Ltd, Inc. v. Commissioner, T.C. Summary Opinion 2013-62, where a $24,000 salary against $240,000 transferred to the owner was raised to $83,200). Recharacterized wages carry employment taxes and interest, plus failure-to-deposit penalties, and the 20% accuracy-related penalty under IRC 6662 can apply to the part of an underpayment attributable to negligence or a substantial understatement.
Under-compensation also affects retirement plan contributions. Contributions to solo 401(k)s, SEPs, and other qualified plans are based on W-2 compensation. Artificially low salaries reduce allowable contributions.
Reasonable compensation works in both directions. For a C corporation, the deduction for owner-employee pay is limited to a reasonable amount under Treasury Regulation 1.162-7, so pay set too high can be challenged. For an S corporation, the usual issue is pay set too low, because wages carry employment taxes and distributions do not.
How BEG helps S-corp owners structure payroll correctly
BEG Managed Payroll helps S-corp clients establish and process reasonable compensation schedules, ensuring FICA compliance while maximizing distribution efficiency as part of fully managed payroll at $45 per employee per month. Learn about BEG Managed Payroll.
Frequently asked questions
What happens if an S-corp owner does not take a salary?
The IRS can recharacterize distributions as wages and assess employment taxes on the recharacterized amount, plus interest and failure-to-deposit penalties. The 20% accuracy-related penalty under IRC 6662 is not automatic; it applies to the part of an underpayment attributable to negligence or a substantial understatement. Officers who perform services for the corporation must receive reasonable compensation.
How is reasonable compensation determined?
Reasonable compensation is what a comparable business would pay a non-owner employee for the same work. Factors include industry pay data, the owner's role and time commitment, and the corporation's financial performance.
Can an S-corp owner take a very low salary?
The IRS has challenged salaries that are unreasonably low relative to distributions. While there is no specific minimum, paying zero or nominal salary while taking substantial distributions is a significant audit risk.
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About the author
Anthony Moretti is VP of Sales at Business Executive Group, where he builds BEG's managed payroll and HR service verticals for employers nationwide. He writes the BEG Payroll Glossary to give employers plain-English answers on payroll and compliance.
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