Electing S Corp status can be a smart tax move for small business owners, freelancers, and single-member LLCs. It allows you to take part of your income as salary and the rest as distributions, which aren’t subject to self-employment tax. But with that benefit comes one rule the IRS pays close attention to—your salary has to be “reasonable.”
That doesn’t mean a salary you’d like to make or a number that helps you minimize taxes. Reasonable compensation is what someone in your position would typically earn if they were hired by another company to do the same job. And in recent years, the IRS has increased scrutiny on S Corps that pay little to no salary while taking large distributions.
If the salary is too low, the IRS can reclassify distributions as wages, add payroll taxes, and apply penalties. If it’s too high, you may pay more in payroll taxes than necessary and reduce the benefit of being an S Corp. So how do you determine the right number? And how do you document it in a way that stands up to IRS standards?
This guide breaks down how reasonable salary rules work today, what’s expected for the 2025 tax year, and how S Corp owners can pay themselves properly without risking an audit.
Table of Contents
- What is a reasonable salary for an S Corp?
- Salary vs distributions
- How the IRS defines “reasonable” in 2025
- How to calculate your salary
- How to pay yourself correctly through payroll
- How Harness can help
What is a reasonable salary for an S Corp?
When you elect S Corp status, the IRS views you in two ways—you’re both a business owner and an employee. Because of that, you’re required to pay yourself a salary for the work you do. That salary must be considered “reasonable” before you can take any profit out of the business as distributions.
A reasonable salary is simply the amount someone would realistically be paid to perform the same services for another company. It isn’t defined by a formula in the tax code, but it is enforceable. Courts have upheld the IRS’s authority to reclassify income when S Corp owners pay themselves too little in wages in order to avoid payroll taxes.
To the IRS, a valid S Corp salary should reflect the actual work performed. If you handle operations, client work, sales, strategy, and financial decisions, you’re more than just a passive owner—and your salary should reflect that level of involvement. If the business is new or not profitable, salary expectations may be lower. But taking no salary at all while the company is making money is one of the most common audit triggers for S Corps.
Before any distributions are taken, the salary has to come first. Only after you’ve paid yourself a reasonable wage can remaining profits be paid out without payroll taxes. That separation (salary first, distributions second) is what makes S Corps work in the eyes of the IRS.
Salary vs distributions
As an S Corp owner, you can pay yourself in two ways: through a salary or through profit distributions. Both are legitimate, but the IRS requires that the salary comes first if the business is generating income.
Your salary is the portion of income you’re paid as an employee of your own company. It runs through payroll, just like any other employee.
Salary is:
- Subject to income tax, Social Security, and Medicare
- Reported on a W-2 at year-end
- Required before you can legally take distributions
Distributions are different. They’re the profits of the business paid to you as a shareholder after a reasonable salary has already been paid.
Distributions are:
- Not subject to Social Security or Medicare taxes
- Reported on Schedule K-1 of Form 1120-S
- Only allowed once a reasonable salary has been paid
The benefit of S Corp status is that distributions avoid self-employment tax. But this is also why the IRS audits S Corps that pay almost no salary and take most income as distributions—it sees that as an attempt to avoid payroll taxes.
If you’re working in the business full-time, you can’t take all income as distributions. If you’re only involved part-time or the business hasn’t generated steady profit, a lower salary may be justified.
How the IRS defines “reasonable” in 2025
The IRS doesn’t give a strict formula for what counts as a reasonable salary. Instead, it uses a set of factors to determine whether the amount you’re paying yourself matches the value of the work you perform. In 2025, enforcement has increased, especially for S Corps reporting high profits with little to no payroll.
When reviewing an S Corp owner’s salary, the IRS looks at:
- What you actually do in the business — Your role, responsibilities, and if you are running operations, providing services, or are largely passive.
- Time spent working — Full-time involvement generally requires higher compensation than a few hours per month.
- Your background — Training, certifications, and experience matter. A licensed CPA running a tax firm is expected to pay more than someone assisting part-time in an early-stage business.
- Gross revenue and profit of the business — If the company can afford to pay employees and take distributions, it should be able to pay its owner a salary.
- What similar businesses pay for similar work — Salary data from industry sources like the Bureau of Labor Statistics (BLS), Glassdoor, or Payscale can be used to support your number.
- Payments to other employees — If non-shareholder employees earn more than the owner, the IRS may question why.
- Whether distributions are being taken — If you’re pulling profit from the business but paying yourself little or nothing in wages, this is a major audit trigger.
The IRS has won several court cases by arguing that owners intentionally underpaid themselves to reduce payroll taxes. In most cases, penalties included back taxes, Social Security and Medicare contributions, interest, and accuracy penalties.
Documenting your salary decision, using market data, profit levels, and your actual responsibilities, is one of the strongest defenses if the IRS ever questions it.
How to calculate your salary
There’s no single formula the IRS requires, but your salary needs to be based on something real, not a number chosen just to minimize taxes. Here are the most commonly accepted methods owners use to determine a reasonable salary.
1. Market salary research
Look at what someone in your role would earn if they were hired by another company. Sources that work well:
- Bureau of Labor Statistics (BLS) wage data
- Glassdoor, Payscale, or Salary.com
- Industry association compensation reports
Documenting this research gives you support if your salary is ever questioned.
2. Role-based percentage approach
Some owners use a percentage split between salary and distributions based on how involved they are in day-to-day work. This is where the unofficial “60/40 rule” comes from—around 60% salary, 40% distributions. It’s not an IRS rule, but can be reasonable if aligned with actual compensation data.
Examples:
- Full-time in the business → salary closer to market rate
- Part-time or advisory role → lower salary may be justified
- First-year or low-profit business → salary could be modest or waived if no distributions are taken
3. Profit-based calculation
Owners sometimes calculate salary based on company profitability. For example:
- Pay yourself what it would cost to replace you
- Then take the remaining profit as distributions
- If profit drops significantly, salary may be temporarily reduced and documented
4. Consider business cash flow
A salary still has to be sustainable for the business. If paying yourself a market-rate salary would put the company at a loss or make payroll impossible, document that and adjust responsibly.
No matter which method is used, the key is documentation—showing how you arrived at the number using real data, not random guesswork. This is often where working with a tax professional is helpful—they can run compensation reports and calculate payroll taxes based on your role and business income.
How to pay yourself correctly through payroll
Once you’ve set your salary, it has to run through a proper payroll system—just like any other employee. That means:
- Registering for payroll taxes with the IRS (EIN) and your state tax agency
- Running payroll regularly (monthly or biweekly is typical)
- Withholding taxes for income tax, Social Security, and Medicare
- Submitting payroll tax deposits using EFTPS
- Filing Form 941 quarterly and state payroll tax forms if required
- Issuing yourself a W-2 at year-end
Distributions come after payroll and are recorded separately—they don’t go through payroll, and no taxes are withheld from them. Keeping salary and distributions separate in your books is important, especially if the IRS ever asks for documentation.
How Harness can help
Many S Corp owners know they need a reasonable salary but aren’t sure how to calculate it, document it properly, or set up payroll the right way. Harness connects you with vetted CPAs and tax advisors who work with S Corp owners every day—helping determine salary, structure distributions, set up payroll, and stay compliant with IRS expectations.
If you want to avoid payroll mistakes, lower audit risk, and build a tax strategy that actually fits your business, get started with Harness today.
Disclaimer
Tax related products and services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. Registration does not imply a certain level of skill or training. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances. This article is a product of Harness Tax LLC.
Content was prepared by a third-party provider and not the adviser. Content should not be regarded as a complete analysis of the subjects discussed. Although we believe the content is reliable, it is not guaranteed as to accuracy and does not purport to be complete nor is it intended to be the primary basis for financial or tax decisions.
This blog contains links to other web sites as a convenience to the reader. These include links to web sites operated by one or more of the following: government agencies, nonprofit organizations and/or private businesses. When you use any of these links, you are no longer viewing our material, and our Privacy Notice will not apply. When you link to another web site, you are subject to the privacy policy of that new site. When you follow a link to one of these sites neither Harness, nor any agent, officer, or employee of Harness warrants the accuracy, reliability or timeliness of any information published by these external sites, nor endorses any content, viewpoints, products, or services linked from these systems, and cannot be held liable for any losses caused by reliance on the accuracy, reliability or timeliness of their information. Portions of such information may be incorrect or not current. Any person or entity that relies on any information obtained from those web sites does so at her or his own risk.