Here is the S-Corp tax saving that everybody knows about: instead of paying 15.3% self-employment tax on every dollar of profit, you pay yourself a salary (subject to FICA) and take the rest as a distribution (not subject to FICA). On a $200,000 profit, that's roughly $15,000–20,000 a year in self-employment tax savings.
Here is the catch that gets repeatedly underestimated: the IRS expects the salary portion to be "reasonable." And "reasonable" is one of the fuzziest words in tax law.
The aggressive game some people play
We see it constantly: an S-Corp owner with $250,000 in net profit pays themselves a $24,000 salary and takes $226,000 as a distribution. They saved roughly $35,000 in FICA. They also created an audit risk that's far larger than the savings.
The IRS has won case after case on this exact pattern. Court precedent is consistent: if your salary is materially below what you'd pay an outside hire to do your job, the IRS will reclassify some of your distribution as wages and assess back FICA, penalties, and interest. Five-year lookbacks are common.
The factors the IRS actually uses
There's no rule that says "60% must be salary." The IRS uses a multi-factor analysis from a 2008 fact sheet, and the courts use the same factors:
- Training and experience — what's your skill level, and what would someone with your skills earn?
- Duties and responsibilities — what do you actually do for the business?
- Time and effort — full-time, part-time, or hands-off?
- Dividend history and shareholder distributions — are distributions large compared to salary?
- Payments to non-shareholder employees — are you paying yourself less than you'd pay someone doing the same job?
- Timing and manner of paying bonuses — does the salary track work, or is it set to maximize the FICA-free distribution?
- What comparable businesses pay — industry data is the cornerstone here.
- Compensation agreements — does any documentation exist?
- Use of a formula — was there a method, or just "whatever was left after distributions"?
What we actually do for clients
Every S-Corp engagement we run includes a reasonable compensation analysis, usually annually. The format is straightforward:
- Identify the owner's role(s) — operations, sales, technical, executive — with rough time allocation
- Pull comparable salary data from the Bureau of Labor Statistics and a paid tool (we use RC Reports for most engagements)
- Adjust for region, industry, and the specific size of the company
- Document the result in a one-page memo we keep with the year's tax file
The output is a defensible salary number. Not the lowest possible salary — the lowest defensible salary. If the IRS audits, we hand them the memo and the analysis. The vast majority of audits stop there.
Common owner archetypes and rough ranges
- Solo consultant or freelancer, $150K–250K profit: salary often falls in the $80K–130K range depending on field
- Husband-and-wife trades business with employees, $300K profit: owner salaries usually $90K–110K each
- Established service firm with team, $500K+ profit: lead owner salary $150K+, often closer to executive comp comparables
- Hands-off owner of a service business with full management team: salary can legitimately be lower because the owner's role is more limited
These are starting points, not answers. The actual number depends on the analysis above, the role, and the comparables.
The cheapest defense against a reasonable-comp audit is contemporaneous documentation. The most expensive defense is improvising one in front of an IRS examiner three years later.
When the answer is "undo the S-Corp election"
Sometimes a profit drop or business shift means the S-Corp election no longer makes sense — the salary the IRS would expect is so close to total profit that the FICA savings are negligible compared to the compliance cost. We've helped clients revoke S-Corp elections more than once. It's a normal step, not an admission of failure.
If you've never had a reasonable comp study done — or if the salary you're running has "never really been thought about" — let's run the analysis. Better to find out now than in an audit.