If you own an S corporation, you may already know that one of its potential tax advantages is the ability to pay yourself through a combination of salary and shareholder distributions. But have you ever stopped to consider whether the salary you’re paying yourself is actually reasonable?
It’s a question that can easily get overlooked, particularly when you’re busy running a business. You may have established your salary years ago when you first formed your company, and as long as the business is profitable and your accountant is preparing your tax returns, you probably haven’t given it much thought. However, as your business grows and your responsibilities change, the amount you’re paying yourself may deserve another look.
With the end of 2026 approaching, now is a good time to revisit your compensation and make sure it still makes sense for your business. Paying yourself too little can create problems with the IRS, but your salary can also affect other aspects of your financial planning that are worth considering.
Why Your S Corporation Salary Matters
One of the reasons business owners elect S corporation tax treatment is the opportunity to reduce certain employment taxes. Unlike a sole proprietor, an owner who works for an S corporation can generally receive both wages and shareholder distributions. While wages are subject to Social Security and Medicare taxes, qualifying distributions are generally not subject to those employment taxes, which can create meaningful savings.
However, this tax advantage comes with an important requirement. The IRS expects S corporations to pay shareholder-employees reasonable compensation for the services they provide before making nonwage distributions to them. This requirement also applies to an LLC that has elected to be taxed as an S corporation.
The concern arises when an owner takes a relatively small salary while receiving substantial distributions, particularly when that owner is personally responsible for much of the work generating the company’s revenue. If the IRS determines that the compensation is unreasonably low, it has the authority to reclassify some of those distributions as wages, potentially resulting in additional employment taxes, interest, and penalties.
That doesn’t mean shareholder distributions are inappropriate or that every successful business owner needs to increase their salary. It simply means there needs to be a reasonable relationship between the compensation you receive and the services you provide to your company.
How Do You Know Whether Your Salary Is Reasonable?
There is no fixed dollar amount or universal formula that determines what an S corporation owner should earn. You may have heard that paying yourself a particular percentage of your profits is enough to satisfy the IRS, but there is no blanket rule establishing an acceptable salary-to-distribution ratio for every business.
Instead, reasonable compensation depends on your particular circumstances. The IRS considers factors such as your experience, responsibilities, time devoted to the business, and what comparable businesses pay for similar services. It also considers how the company generates its revenue, including whether that income comes primarily from your personal efforts, the work performed by employees, or the company’s equipment and other assets.
For example, consider two business owners who each operate profitable companies. One is a consultant who personally provides nearly all the services, manages client relationships, and handles the company’s daily operations. The other has an established business with employees who perform most of the work, allowing the owner to spend considerably less time on day-to-day activities. Although both companies may generate similar profits, the owners’ reasonable compensation could be quite different because their responsibilities are different.
Of course, delegating work doesn’t necessarily mean an owner’s responsibilities have disappeared. Managing employees, overseeing operations, bringing in new business, and making important financial decisions are also valuable services. The appropriate salary should take those responsibilities into account rather than focusing solely on the number of hours spent providing services directly to customers or clients.
Ultimately, the goal isn’t to determine the lowest salary you can get away with paying yourself. It’s to establish compensation that accurately reflects your role and that you can reasonably support if the IRS ever questions it.
For additional guidance, the IRS explains the factors it considers when evaluating reasonable compensation for S corporation shareholders.
Has Your Business Changed Since You Established Your Salary?
Think about what your business looked like when you first established your compensation. Were you handling nearly everything yourself? Did you have employees? Were you spending most of your time providing services, or were you primarily responsible for managing the business?
Now consider how much has changed. Perhaps you’ve expanded your operations, hired employees, increased your revenue, or taken on responsibilities that didn’t exist when you started. On the other hand, you may have reached a point where you’ve stepped back from daily operations and delegated much of the work to others.
These changes don’t automatically mean your salary needs to increase or decrease, but they may affect what constitutes reasonable compensation. A salary that was appropriate five years ago may no longer accurately reflect the work you’re performing today, particularly if your role has changed significantly.
This is also a good reminder that other aspects of your business may need attention as your company evolves. In my earlier article, Has Your Business Outgrown Its Legal Documents?, I discussed how business owners often continue operating under agreements and documents that were prepared when their companies looked very different. Just as your compensation should reflect your current responsibilities, your business documents should reflect how your company actually operates today.
Why Proper Documentation Is Important
Determining an appropriate salary is only part of the process. It’s also important to maintain documentation showing how that amount was established, especially if you’re receiving significant shareholder distributions in addition to your wages.
Your CPA can help you evaluate comparable compensation, review your responsibilities, and determine what information should be maintained to support your salary. Depending on the circumstances, this may include a written description of your duties, estimates of the time you devote to the business, compensation data for similar positions, and an explanation of how the amount was determined.
From a legal standpoint, it’s equally important to make sure your company’s records accurately reflect its compensation arrangements. Corporate resolutions, employment agreements, and other governing documents may be relevant, particularly when a business has multiple shareholders or agreements addressing how owners are compensated.
Disagreements over compensation and distributions can become especially problematic when there are multiple owners. One shareholder may be actively managing the business while another has little involvement in daily operations, yet both may have ownership rights to distributions. Clearly documenting compensation arrangements and understanding how they differ from ownership distributions can help prevent misunderstandings and disputes.
Maintaining appropriate records is part of operating a business properly. It’s much easier to address these matters while everyone is working together than to sort them out after questions or disagreements arise.
Your Salary Can Affect More Than Your Taxes
Although reducing employment taxes is often the primary reason business owners consider S corporation compensation strategies, the amount you pay yourself can have consequences beyond your annual tax return.
For example, if you participate in a retirement plan through your business, your W-2 compensation generally affects how much you can contribute under the plan’s rules. Shareholder distributions don’t count as earned income for retirement plan contribution purposes, so paying yourself an unnecessarily low salary could limit certain opportunities to save for retirement.
Your salary also contributes to your Social Security earnings record, which can affect your eligibility for and the amount of future retirement or disability benefits. Depending on the terms of your insurance policies, compensation may also be relevant to disability insurance benefits and other financial protections.
These considerations are worth discussing with your CPA and financial advisor when evaluating your overall compensation strategy. Saving money on employment taxes may be beneficial, but you also want to understand how those decisions affect your long-term financial security.
Why You Should Review Your Compensation Before Year-End
With the end of the year approaching, now is an appropriate time to ask your CPA whether your current salary remains reasonable. This is particularly important if your business has experienced significant growth, your responsibilities have changed, or you’ve taken substantial shareholder distributions during 2026.
Your CPA can review your year-to-date payroll, distributions, financial statements, and the services you’ve provided to determine whether your compensation should be adjusted. If an issue is identified, addressing it before the final payroll deadlines may provide an opportunity to make appropriate changes rather than discovering the problem when your tax returns are prepared next spring.
It’s important to understand, however, that simply issuing yourself a year-end bonus doesn’t necessarily resolve every compensation issue. Depending on the circumstances, there may be earlier payroll reporting obligations or tax deposits that require attention. Your CPA and payroll provider can help determine the proper course of action and whether any corrections are necessary.
Even if your review confirms that your current salary is appropriate, you’ll have the benefit of knowing that the decision has been considered and that your records support the amount you’re receiving.
Good Business Planning Goes Beyond Your Tax Return
Running a successful business involves far more than managing revenue, expenses, and taxes. As your company grows, the decisions you make about ownership, compensation, management, and succession can have lasting consequences for both your business and your family.
While your CPA is the appropriate professional to help determine reasonable compensation and evaluate the related tax consequences, your legal planning deserves attention as well. Your business structure, governing documents, ownership arrangements, and estate plan should work together so that you’re prepared not only for the company’s continued success but also for unexpected circumstances.
For example, if you became incapacitated and could no longer manage your business, would someone have the legal authority to step in and make decisions? If you passed away unexpectedly, what would happen to your ownership interest, and would your family have a clear understanding of how the business should be handled? These are issues that business owners sometimes overlook while concentrating on the daily demands of running their companies.
At Cheever Law, I help business owners with business entities, estate planning, and business succession planning, including coordinating business ownership interests with their personal estate plans. Whether you’re operating a relatively new business or have spent years building a successful company, it’s important to make sure your legal arrangements continue to reflect your circumstances and goals.
As you review your business finances before year-end, consider taking some time to review the legal arrangements protecting what you’ve built. If your business has changed significantly or your estate plan hasn’t been updated in several years, contact Cheever Law to discuss whether your planning needs attention.