What is a Reasonable Salary for an owner of an s-corporation?

Many people have heard that the S Corp is one way to save on business taxes.  While this is true to an extent, there is a lot of misinformation, so let’s try and clear up what S Corporation actually means, the tax advantages and some common pitfalls. 

What is an S Corporation?

Let’s start with defining an S Corporation and how it is taxed. An S Corporation, Subchapter S Corporation, or S Corp, is a corporation or Limited Liability Company that elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. In order to elect S Corp status, you need to file IRS Form 2553 and qualify by meeting requirements including being a domestic corporation, having 100 or fewer shareholders that are individuals or some types of trusts and estates, have only one class of stock, and not be an ineligible corporation. (1)

The concept of the income or loss passing through means that the owners can share the income/loss of the S Corp in the form of distributions, like how a general partnership would share it among partners. 

Instead of paying taxes on self-employment income, as one would as a sole proprietorship or partnership, the business must withhold FICA taxes and federal income taxes from employee pay and, the business must also pay those FICA taxes along with other employment taxes. 

A major tax benefit of S Corps is that the shareholder-employees do not have to pay self-employment tax (15.3% of earnings) on all of the company’s net profits, which could result in a significant payroll tax savings.  Self-employment taxes consist of 12.4% Social Security tax, plus 2.9% Medicare tax.  Combining those the two tax rates brings you to 15.3%. The net business profits of sole proprietorships and partnerships are subject to self-employment taxes. Electing to be taxed as an s-corp means that any shareholder distributions that aren’t salary are not charged the self-employment tax. Another big tax benefit of electing S Corp status is avoiding double-taxation that corporations face. Double-taxation occurs because the entity pays tax on business income, and the corporation’s shareholders pay tax on their dividends.

While that sounds great and easy to do, the Internal Revenue Service isn’t going to just let you minimize compensation in favor of corporate distributions. The caveat to not paying self-employment tax on the distributions is that if the owners provide any kind of service to the company, they must receive “reasonable compensation” in the form of wages/salaries as an employee. These wages are subject to employment tax, which will be discussed shortly.

Well, you don’t have to pay payroll taxes on distributions from your S corporation. Distributions are the earnings and profits that pass through the corporation to you as an owner (shareholder). Keep in mind that distributions are not your employee wages.

What is a reasonable salary?

According to the IRS the right amount of salary to pay depends on many factors, with the major one being industry standards. The salary must be a reasonable amount of compensation, which is open to interpretation but is often considered the median salary someone would earn doing what you do at your company.

The following factors are a few factors the IRS uses when evaluating reasonable owner income:

  • Time and effort devoted to the business
  • Prevailing rates comparable businesses pay for similar services
  • Professional experience
  • Duties and responsibilities
  • Gross and net income of the business
  • Business dividend history payments
  • Dividend and bonus history

S corporations must pay reasonable wages to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. Cash distributions aren’t going to count towards reasonable compensation amounts. 

Also, the total amount of reasonable employee compensation is not just the annual salary paid.  It also includes health insurance premiums and HSA contributions. 

Also see: How to pay yourself as a business owner

Dangers of paying owners low wages

The ideal tax situation is to pay yourself $0 salary and the remaining as a distribution. Paying yourself zero salary and the rest in distributions is the riskiest play. Many businesses get away with this, however, there is a substantial risk of an IRS audit. 

You could pay yourself 100% in salary and no distributions which while is the safest route, your tax bill is going to be higher.  What the right amount is and the risk someone is willing to take is going to vary significantly between each person. Basically, the only tax savings an S Corp provides is the reduction of self-employment taxes, which includes Social Security and Medicare taxes (payroll taxes).  As an example, if you are paid $100,000 in shareholder wages, 7.65% is withheld for the employee’s portion of payroll taxes. This is broken down into 6.2% Social Security and 1.45% Medicare. The business will also pay 7.65% for a combined percentage of 15.3%.  This $100,000 shareholder salary costs you $15,300 in additional taxes. 

Tax advisors and the owners of S corporations are often at odds when setting the shareholder-employee’s compensation. Typically, the shareholder-employee will want to minimize compensation in favor of distributions to reduce payroll taxes. Tax advisers, however, are faced with growing scrutiny from the Internal Revenue Service stating the shareholder-employee cannot avoid payroll taxes by forgoing reasonable compensation. 

Because of the opportunity for substantial employment tax savings, the IRS has challenged attempts by shareholder-employees to minimize compensation in favor of distributions. 

There have been many cases tried in Tax Court for unreasonable shareholder salaries. An example is a 2012 case, David E. Watson, PC vs. U.S. A shareholder of an S Corp, who was a CPA of a tax accounting firm, received employee wages of $24,000 per year and dividend distributions of nearly $200,000 per year in 2002 and 2003. The case went to trial, and the government expert testified that the value of Mr. Watson’s services to the firm was $91,044 per year. The Tax Court concluded that any reasonable person in Watson’s role would be expected to earn far more than he was paying himself and rendered a tax deficiency judgment against the firm, which included unpaid employment taxes, penalties, and interest. 

The basic idea here is that employee salary should never be less than distributions. This ratio obviously doesn’t apply in every situation, but it can be a useful rule of thumb in some cases.

Another court case determined that a shareholder should not be paid a lower salary than other less-experienced employees in the business. There can be exceptions, most notably is when there aren’t sufficient profits or cash to pay the owners an appropriate salary.

In each case, shareholder-employees who provided significant services to their S corporation and withdrew sizeable taxable income from their corporation as distributions, neglecting to take any salary. The Tax Court held that the shareholders were employees and recharacterized the distributions as compensation.

In this case and many others, the IRS used a valuation expert who evaluated financial ratios from the Risk Management Association (RMA), which is a company that catalogs industry ratios.  You can use this information as well to evaluate average shareholder salaries in your industry, which can help from being the target of an IRS audit.

Under Section 3401(c) of the Internal Revenue Code, an employee is typically defined to include any officer of a corporation. Almost all S Corporation owners are, to at least some degree, actively engaged in running their corporation, and very frequently fulfill the role of an officer. In some circumstances, when shareholders who are also officers of a corporation, but only provide minor services to the business are not considered employees of the corporation. The key point to consider is they are not entitled to receive direct or indirect compensation.

How to reporting salaries and distributions on taxes

We now know that the S corporation owners (who provide services to the company) receive both a salary and distributions. The salary is compensation for their work, and the distributions are a share of the company’s profits. How are they reported on taxes?

The S Corp as an entity needs to file a Form 1120S for its annual U.S. Income tax return. Schedule K on Form 1120S shows the taxable income information. Each owner’s “distributive share,” or the distributions of the company’s income, is shown on their Schedule K-1, which is filed with their personal tax return.

Salaries, however, are subject to FICA (Federal Insurance Contributions Act) and FUTA (Federal Unemployment Tax Act), which are federal payroll taxes. For FICA, the taxes deducted from each paycheck are 6.2% of gross wages for Social Security tax and 1.45% of gross wages for Medicare tax, and the employer (or the S Corp), is responsible for matching it, for a total of 15.3%. The S Corp’s portion of FICA taxes are reported quarterly using Form 941 – Employer’s Quarterly Federal Tax Return. For FUTA, the S Corp pays 0.6% (if the state is eligible for a credit) of the first $7,000 of wages paid to employees in a calendar year. FUTA is reported annually on Form 940 – Employer’s Annual Federal Unemployment Tax. (4)

Impact from the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act (TCJA) that began in 2018, further complicates calculating employee wages for S Corps.  While S corporations are still attractive to avoid Social Security and Medicare tax the TCJA instituted a new pass-through tax deduction, allowing S corp owners and other pass-through entities to deduct up to 20% of their net business income from their Federal income taxes.

There are a few limitations, such as total taxable income (which includes all W2 income) so be sure to talk with your tax professional to see if you qualify for the 20% deduction.

Simplifying Recordkeeping with Payroll Services

Keeping up with employment taxes is a job in itself, especially as the number of employees in your company grows. Thankfully, there are payroll services to help streamline the process. A payroll service, such as ADP or PayCom, will use employees’ wages to “calculate gross wages, subtract all pertinent withholdings and deductions, print checks, make direct deposits, and prepare all employment tax filings.” (5)


Small businesses can be incredibly costly for a new business owner. Now that you understand how S Corps are taxed, you can evaluate whether the tax benefits of electing S Corp status could be helpful for you in your small business endeavors.

  1. “S Corporations,” IRS, last modified July 31, 2020, https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations.
  2. “Wage Compensation for S Corporation Officers,” IRS Fact Sheet filed by the Media Relations Office, FS-2008-25, August 2008, https://www.irs.gov/pub/irs-news/fs-08-25.pdf.
  3. David E. Watson vs. U.S., filed by the United States Court of Appeals for the Eighth Circuit, No. 11-1589, filed February 21, 2012, https://ecf.ca8.uscourts.gov/opndir/12/02/111589P.pdf.
  4. “What is FICA?” Social Security Administration, Publication No. 05-10297, Match 2017, https://www.ssa.gov/thirdparty/materials/pdfs/educators/What-is-FICA-Infographic-EN-05-10297.pdf