Reasonable compensation (S-Corp)

S-Corporation owner-employees must take reasonable compensation for the services they perform for the company. The IRS scrutinizes the salary-vs-distribution split because distributions avoid the 15.3% self-employment tax (split into 6.2% Social Security and 1.45% Medicare on each side).

Why it matters

A common founder mistake: take a $20,000 W-2 salary and $300,000 in distributions from a profitable S-Corp. This invites IRS reclassification of distributions as wages, triggering back payroll taxes, penalties, and interest.

What "reasonable" means

The IRS hasn't published a bright-line test, but several factors emerge from case law (Watson v. United States, etc.):

• What similar work pays in your market (comparable role + experience + location)
• Training and experience of the employee
• Duties and responsibilities
• Hours worked
• Compensation paid to non-owner employees in similar roles
• Business profitability

Documentation

The standard defense is a compensation study that documents:

• BLS data for the role + region
• Industry compensation surveys (RIA: InvestmentNews; tech: AngelList; etc.)
• Comparable role postings (LinkedIn, Indeed)
• Owner's contribution to the business

Without documentation, the IRS reclassification argument is strong. With documentation, even an aggressive split (e.g., $80K salary on $400K of profit) is defensible.

Coordination with QBI

S-Corp owners need to balance reasonable comp against QBI. Above the QBI phase-out threshold, the QBI deduction is limited to the lesser of 20% of QBI or 50% of W-2 wages — pushing reasonable comp too low can hurt the deduction.

A common optimization: 28% reasonable comp / 72% distribution for service businesses near the QBI threshold.