Save Money On Your Taxes
S Corp Salary Rules: How to Pay Yourself Without IRS Trouble
Electing to be taxed as an S Corporation can create significant tax savings for small business owners, but it also comes with an important responsibility: paying a reasonable salary.
It’s one of the most common areas of confusion we see at Vallou. While the structure can help reduce payroll taxes, underpaying yourself can quickly create IRS issues that outweigh any savings.
Why the IRS Cares About Your Salary
When a business elects S Corporation status, the IRS expects the owner to be treated like an employee.
That means:
Taking a W-2 salary for the work performed
Withholding and remitting payroll taxes
Reporting compensation accurately each quarter
If owners could take 100% of profits as distributions, payroll taxes would disappear altogether. That’s why the IRS keeps a close eye on S Corp owner compensation. It’s a major compliance area and a common audit trigger.
What Counts as “Reasonable Compensation”
The IRS doesn’t publish a fixed formula. Instead, it looks at whether an owner’s salary aligns with the market value of the services performed and the economics of the business. In practice, that means considering:
Your role and responsibilities – What would you pay someone else to do your job?
Industry standards and location – Compensation varies based on profession and region.
Profitability and size of your business – The higher your profits, the more scrutiny your salary will face.
The IRS evaluates what you actually do for the company and how the business generates its receipts (your services vs. non-owner employees vs. capital or equipment) when assessing whether your compensation is reasonable.
A good rule of thumb: if your business earns $150,000 in profit, a $30,000 salary is rarely defensible. A salary closer to $60,000 to $90,000 might be more appropriate depending on your industry, duties, and revenue mix.
The Risks of Paying Yourself Too Little
Choosing a low salary can lead to expensive consequences:
Reclassification of distributions: The IRS may reclassify part or all of your distributions as wages and assess back payroll taxes plus penalties.
Audit exposure: Low salaries relative to business profit stand out, especially for service-based businesses.
Financing issues: Low reported wages can hurt your qualifying income for loans or mortgages.
Cutting corners here can create more cost and stress later.
Overpaying Yourself Isn’t Ideal Either
Paying yourself too much can be just as problematic. It:
Increases payroll tax unnecessarily
Reduces the profit available for tax-efficient distributions
Can strain business cash flow
The right balance is a salary that’s both defensible and sustainable.
How to Determine a Defensible Salary
At Vallou, we help business owners determine a reasonable compensation number using industry data and defensible methodology.
Here’s a simple framework to approach it:
Start with market data: Look at compensation ranges for similar roles in your field and region.
Adjust for your business model: Your salary should reflect how much of your time is spent in billable work versus management.
Document your reasoning: Keep notes or reports supporting how you arrived at the number. If the IRS ever asks, documentation ends the conversation quickly.
Review annually: Revisit your salary each year as your role or profitability changes.
Taking Distributions the Right Way
After paying a fair salary and setting aside funds for taxes, owners can distribute remaining profits. Key points to remember:
Only take distributions from actual profit and available basis, not from funds needed for operations.
Keep distributions consistent and proportional to ownership.
Avoid taking distributions in excess of your stock and debt basis. Distributions above basis are generally taxable and must be tracked on Form 7203.
Consistency signals professionalism and keeps the books clean.
An Example in Practice
Let’s say a Company nets $200,000 in profit.
A reasonable salary for the owner might be around $80,000 to $90,000.
Payroll taxes apply to that salary, not the remaining $110,000 to $120,000 in profit.
The owner can then take periodic distributions from those remaining profits.
We would document the data and rationale supporting the $80,000 to $90,000 salary range to substantiate “reasonable compensation” if ever questioned.
This structure balances compliance and efficiency and supports long-term stability.
The Bottom Line
S Corporations offer excellent benefits, but the savings only work when compensation is handled properly.
A well-supported salary helps you:
Stay compliant
Strengthen financial credibility
Avoid costly IRS reclassifications
At Vallou, we help business owners establish the right compensation structure that balances compliance, cash flow, and long-term tax strategy.