Reasonable compensation is what you would pay someone else to do your job. There is no safe percentage and no bright line — the standard is what the role is worth in your market, documented before you set the salary rather than justified afterwards.
The S corp election works because salary and distributions are taxed differently. That is also precisely why the salary figure attracts scrutiny — the smaller it is, the larger the untaxed portion becomes.
The standard, stated plainly
Reasonable compensation is what you would have to pay an unrelated person to perform the same duties. Not a percentage of profit, not a round number, and not the minimum you can justify.
It follows the work rather than the profit. An owner doing skilled billable work full time has a higher reasonable salary than one who has hired a team and now oversees it, even if the second business is more profitable.
What actually supports a figure
A written description of what you do and roughly how many hours it takes. Market data for that role in your area. An acknowledgement of duties that fall outside it, if you also do administrative or lower-skilled work.
Written down when you set the salary, not assembled after a notice arrives. The difference between those two is most of the defensibility.
Where owners go wrong
Applying a percentage they read somewhere. Setting the salary at whatever leaves the desired distribution. Never revisiting it as the business grows and the role changes.
That last one is common and quiet: a salary set reasonably in year one becomes indefensible by year four while nobody looks at it.
The bookkeeping side
Salary runs through payroll with withholding and employer taxes. Distributions do not and should be posted separately. Where the two are blended into a single owner draw account, neither the return nor the payroll filings will reconcile.
Keeping them separate all year is what makes the year-end conversation short.
Different owners, different answers
A solo consultant billing their own time is close to a straightforward employment substitution — the salary looks like what a senior employee doing that work would earn. There is not much room to argue it down.
An owner who has built a team and now spends most of their time on strategy has a different role, and a defensible salary reflects that role rather than the total profit the business generates. Profit produced by other people’s labor is not compensation for yours.
An owner working part time in a business with substantial passive income is different again. The salary follows the hours and the duties.
Revisit it annually
Set it at the start of the year with the year’s expected role in mind, and record why. When the role changes materially — you hire a manager, you stop doing billable work, you double your hours — the figure should move with it.
A salary that has not changed in five years while the business tripled is the pattern that looks least considered.
What to keep on file
A one-page memo: duties, approximate hours, the market data you used and where it came from, and the resulting figure. Dated.
It takes twenty minutes a year and it is the difference between a position you can explain and one you have to reconstruct under pressure.
Common questions
- What is reasonable compensation for an S corp owner?
- What the role would cost to hire out, based on duties, hours, experience and market rates. It is a facts-and-circumstances question rather than a formula.
- Is there a 60/40 rule?
- No. Percentage splits circulate widely and none of them is in the law. A percentage that happens to land near a defensible salary is a coincidence, not a safe harbor.
- What happens if I pay myself too little?
- Distributions can be reclassified as wages, with back payroll taxes, penalties and interest. It is one of the more commonly examined S corp issues.
- How do I document it?
- Record the duties, the hours, the market data you relied on, and the date you set it. Contemporaneous reasoning is worth far more than a reconstruction.
- Can I take no salary in a loss year?
- If there were no distributions and little activity, possibly. Taking distributions while paying no salary is the specific pattern that draws attention.
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