Hey there y'all! I hope everyone is doing well today.
I want to talk about reasonable compensation...and I know, the phrase itself sounds like something out of a compliance manual, but stick with me here. This is the question I get more than almost any other from people who just elected S-corp status, and it usually arrives with a little bit of panic attached to it. Somebody made the election because a friend or a video told them it would save money, and then a few weeks later it hits them that they now have to pick a number, and nobody told them how.
And every single time I answer this one, I get a little better at explaining it (at least I hope so). So here's this round's attempt.
Here's what actually happens. You do the election, you feel pretty good about it, and then your payroll provider asks what your salary should be...and you realize you have no idea. There's no chart. There's no IRS calculator. You go looking for an answer and you find a hundred people confidently naming a percentage...all of them different, none of them citing anything.
So you guess. And then you spend the rest of the year quietly wondering if you guessed wrong.
Why the IRS cares about this at all
When you own an S-corp and you work in it, you're two things at once, and this is the part that trips people up the most.
You're an owner...which means you're entitled to your share of the profit. And you're also an employee, which means the company has to pay you for the work you do. Those are two different relationships that happen to involve the same person, and the tax code treats them completely differently.
Money that comes to you as wages carries payroll tax - 15.3 percent, split between the employee side and the employer side, except you're both sides. Money that comes to you as a distribution of profit does not carry payroll tax at all.
You can probably see where this is going. If nothing stopped you, the obvious move would be to pay yourself a salary of about eleven dollars and take everything else as a distribution... and you'd have quietly opted out of Social Security and Medicare entirely.
That's the whole reason this rule exists. Everything else is detail.
But the detail is where people actually get stuck, so here's where we're going. First, what the standard actually is, since it's not a percentage and never has been. Then how to build a number you could defend out loud, which is more straightforward than it sounds. And then the mistake I see most often, which has nothing to do with the number itself. Stay with me and I think you'll walk away with an actual method instead of a vague worry.
One: the standard is a question, not a formula
The IRS position is that an S-corp has to pay reasonable compensation to a shareholder-employee for services actually rendered, before non-wage distributions go out. And when they evaluate whether a number is reasonable, they look at things like your training and experience, your duties, the hours you put in, what comparable businesses pay for that work, and what you're paying everybody else.
Notice what's not in there. No percentage. No ratio. No safe harbor. Nothing you can just look up.
You've probably heard the 60/40 rule - 60 percent salary, 40 percent distributions. I hear it constantly. It is not in the code, it is not in a regulation, and the IRS has never endorsed it. Somebody said it once, it sounded reasonable, and it's been repeating itself ever since...like a rumor that got a job.
The actual test is a lot more human than a formula. What would you have to pay somebody else to walk in tomorrow and do your job?
That's it. That's the question. If you can answer it honestly and show your work, you're in good shape.
Two: building a number you could defend
Let me do this with someone real-ish. Say you run a small design studio, structured as an S-corp, and the business clears about $180,000 after expenses.
You're not one job. You're probably four.
You do the actual design work, which is most of your week. You do sales and client management, which is a chunk of it. You do project management, keeping things moving and on schedule. And you do the admin - invoicing, email, the stuff nobody pays for but somebody has to do.
So break it up. Look up what each of those roles pays in your area - the Bureau of Labor Statistics publishes wage data by occupation and state at bls.gov, and it's free. Then estimate how your week actually splits across those four roles, and weight it.
Maybe designer is 50 percent of your time at around $75,000. Account and sales work is 20 percent at around $70,000. Project management is 20 percent at around $80,000. Admin is 10 percent at around $45,000. Weight those out and you land somewhere around $72,000.
Then sanity-check it. You're not a mid-level employee...you're the person the whole thing depends on, so nudging up from there is reasonable. Call it $78,000 and write down how you got there.
That last part is the part people skip, and it's the most valuable thing in this whole article. A one-page memo saying "here are my roles, here's the wage data I used, here's my time split, here's why I adjusted" turns a guess into a position. You will almost certainly never need it. If you ever do need it, nothing else will substitute for it.
Three: the mistake that isn't about the number
Here's the one I see most, and it has nothing to do with whether you picked $72,000 or $78,000.
It's running payroll once, in December, for the whole year.
I understand why it happens. Cash was tight, you kept meaning to set it up, and then suddenly it's the fourth quarter and you need a W-2 to exist. But a single December payroll run looks exactly like what it is - a number picked after the fact to make the return work. Regular payroll on a real schedule looks like a business paying an employee, because that's what it is.
Run it monthly at minimum. Biweekly if you can. The consistency is doing quiet work for you all year...you just don't see it doing it.
One more thing worth knowing before you go set your number as low as you can get away with: your salary drives how much you can put into a Solo 401(k) or SEP-IRA, and it feeds into the qualified business income deduction in ways that can cut against you at higher incomes. Minimizing the salary is not automatically the winning move. It's a lever with more than one thing attached to it, and that's genuinely worth a conversation rather than a rule of thumb.
What to do this week
Go to bls.gov and look up one role...just one, the one you spend the most time doing, for your state. Write down the median.
That single number is the beginning of your memo, and you'll have it in about four minutes.
If you've been carrying a low-grade worry about your salary number all year, I'd rather you replace it with a piece of paper. And if you want a second set of eyes on the split, that's exactly the kind of thing I like working through.
This is education, not advice, and reading it doesn't make you a client. And if you already are a client - this kind of general writing sits outside our engagement. Your engagement covers your return, your books, your situation. This covers everybody's, which means it can't really cover yours. So before you act on any of it, reach out and let's talk about your actual numbers. That's what the individual advice is for. Information current as of August 2026.
Where I'm getting this: IRS, S Corporation Compensation and Medical Insurance Issues · IRS, Self-Employment Tax · SSA, Contribution and Benefit Base · IRS, Qualified Business Income Deduction · Bureau of Labor Statistics, Occupational Employment and Wage Statistics
Varde Financial, LLC · Abel Scott, EA · vardefi.com
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