If you’ve made the leap to becoming an S Corporation, congratulations! That’s a big step toward building a business that works smarter for you. But with that new tax filing status comes a not-so-fancy but incredibly important responsibility: paying yourself a reasonable salary.

Wait—what’s “reasonable,” anyway? And who decides?

Let’s unpack it together.

What Is Reasonable Compensation?

In plain English, “reasonable compensation” is the salary you, as an owner-employee of your S Corporation, should pay yourself for the work you actually do. Not the profits you take home. Not the distributions you get as an owner, just the pay for services rendered.

The IRS expects S Corp owners who perform work for the business to pay themselves a salary comparable to what they’d pay someone else to do the same job.

So, if you’re wearing all the hats—CEO, salesperson, hiring director, social media guru, and janitor—your salary should reflect that.

Why Reasonable Compensation Matters

S Corp owners don’t pay self-employment tax on distributions. That’s one of the reasons electing S Corp status can be beneficial: it can lower your overall tax burden compared to paying taxes as a limited liability company (LLC).

That’s a huge perk, but there’s a catch. If you underpay yourself on salary and take excessive distributions, the IRS may raise an audit flag.

It doesn’t matter if the business is making or losing money. What matters is whether you’re taking money (or anything else of value) out of the S corporation.

If an IRS agent thinks you’re underpaying yourself to dodge payroll taxes, you could face back taxes, penalties, and interest. Ouch.

So… What’s Considered “Reasonable”?

Ah, the million-dollar (or maybe $75,000-a-year) question. Reasonable compensation depends on:

• Your role in the company
• The size and profitability of your business
• Your experience and training
• What others in your industry earn
• How many hours you work
• The location of your business (yes, even that matters—an office in Cedar Rapids, Iowa might pay differently than one in Manhattan or L.A.)

Here’s a quick example:

Say you run a digital marketing agency and handle most of the client work yourself. A typical salary for a full-time marketing consultant in your area is $70,000 per year. If your business earns $150,000 net profit and you’re paying yourself only $20,000 in salary with the rest as distributions, that’s a red flag.

How to Determine a Fair Salary

Now that you know you need to pay yourself a reasonable salary, how do you figure out what’s reasonable? Unfortunately, the IRS doesn’t publish a guide to reasonable wages.

Start with these steps:

1. List out your job duties. How many roles do you fill, and what’s the highest-value role you fill?
2. Estimate the time you spend on each.
3. Research industry pay rates for each service you perform. Use tools like the Bureau of Labor Statistics (BLS.gov), Salary.com, or Glassdoor.
4. Blend it together. Assign a reasonable hourly rate or annual salary to your work.

You don’t have to pay yourself a sky-high salary that eats all your profits. You just have to pay something that makes sense. Remember, you can still take distributions in addition to your reasonable salary, and these are still exempt from self-employment tax.

So instead of skipping salary or overdoing it, aim for the sweet spot: what you’d pay someone else to do the same job you do.

Put the Pencil Down, We’ll Help with the Math

We understand: tax rules can seem like a maze. However, when it comes to S Corp salary rules, the key is simple: pay yourself like you’d pay a fellow employee, because you are one.

If you’re not sure what’s “reasonable” for your situation, don’t go it alone. NewWay Accounting can help you figure out a fair, defensible salary that keeps you out of trouble with the IRS and helps you sleep better at night.

If you’d rather not wade through government databases and salary tables, we’d be happy to prepare a reasonable wage analysis and report for you. Just reach out, and we’ll crunch the numbers while you focus on running your business.