Preface: “Chase the vision, not the money; the money will end up following you.” –Tony Hsieh
Understanding Reasonable Compensation for S-Corporations (Made Simple)
If you own an S-Corporation or plan to, there’s one important rule you need to know about: reasonable compensation. It might sound like a technical tax term, but it really just means: Are you paying yourself a fair salary for the work you do?
Why It’s a Big Deal
S-Corporations are special kinds of businesses where the company’s profits “pass through” to the owner’s personal tax return. This setup helps avoid some business taxes—but it also comes with IRS rules.
If you work in your S-Corp (not just own it), the IRS says you’re an employee, not just an owner. That means you have to take a real paycheck (with payroll taxes), not just profits or “distributions.” Why? Because wages get taxed differently from profits. And if the IRS sees that you’re only taking profits and no paycheck, they might hit you with taxes, penalties, and interest.
What Counts as “Reasonable”?
The IRS says reasonable compensation is the amount you would pay someone else to do your job in your business. So, if you’re doing full-time management, your pay should match what someone in that role would normally earn.
Here are some things the IRS looks at when deciding if your pay is reasonable:
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- What kind of work you do
- How much time you spend working
- Your skills and experience
- What you pay other employees
- What similar jobs pay at other businesses
- How much profit your business makes
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The idea is to make sure your salary isn’t too low (to avoid taxes) or too high (which could hurt your business financially).
Why Getting This Right Matters
If you underpay yourself, the IRS might say some of your profits should’ve been wages. That means:
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- You could owe back payroll taxes
- You could face penalties and interest
- You might even risk your S-Corp status
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On the flip side, paying yourself too much means your business pays more employment tax than necessary.
So, What’s the Right Salary?
It depends on what you actually do for the business. For example:
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- If you work 40 hours a week and run day-to-day operations, you should get a market-rate salary.
- If you only help out once in a while or offer advice, a smaller salary might make sense.
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The goal is to find a fair balance that matches your role and how similar businesses pay.
How a CPA Can Help You
Getting reasonable compensation right can be tricky. That’s why it helps to work with a CPA They can:
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- Look at your role and what you do day to day
- Compare what others in similar roles earn
- Review your current pay and business profits
- Help you figure out benefits and taxes
- Keep records in case the IRS ever asks questions
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Final Thoughts
Paying yourself fairly from an S-Corporation isn’t just about following the rules—it’s smart business. It helps you avoid IRS problems, pay the right taxes, and keep your business strong.