Reasonable compensation
The factors that set an S corporation owner's salary, and the payroll and distribution entries that follow.
The IRS doesn't publish a number. It lists the factors that set what is reasonable for the work: training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, payments to non-shareholder employees, the timing and manner of bonuses to key people, what comparable businesses pay for similar services, compensation agreements, and the use of a formula. Too low a salary is the classic S corporation audit issue.
The consultant's year in the books: the salary runs through payroll with FICA withheld and matched, and the remaining profit goes out as a distribution, which is equity, not an expense — the S corporation's counterpart of an owner's draw or a dividend. These are summary entries for the year, before income tax withholding.
Shareholder-employee payroll
| Account | Debit | Credit |
|---|---|---|
| 6000Officer wages | 90,000.00 | |
| 6050Payroll tax expense | 6,885.00 | |
| 1000Cash — operating | 83,115.00 | |
| 2100Payroll liabilities | 13,770.00 | |
| Balanced | 96,885.00 | 96,885.00 |
The salary for the year, with both halves of FICA.
Distribution to shareholder
| Account | Debit | Credit |
|---|---|---|
| 3300Shareholder distributions | 53,115.00 | |
| 1000Cash — operating | 53,115.00 | |
| Balanced | 53,115.00 | 53,115.00 |
The rest of the profit, distributed.
Wrong
No salary; $150,000 taken as distributions.
Right
$90,000 salary through payroll, $53,115 distributed.
Paying no salary and taking everything as distributions is exactly what the rule forbids. The IRS can reclassify distributions to an officer as wages, to the extent they are reasonable compensation for the work, and collect the employment taxes on them.
Where this lesson's rules come from
The sources behind this lesson's requirements, by kind. Anything marked as a convention is ours, not the rule-maker's.
- IRS guidance
- IRS, S corporation compensation and medical insurance issues (opens in a new tab)Reasonable compensation, and the factors that set itFree to read
- IRS, S corporation compensation and medical insurance issues — reclassification (opens in a new tab)Distributions in place of a salary can be reclassified as wagesFree to read
- IRS Pub. 15 (2026), What's New (opens in a new tab)Social Security and Medicare tax for 2026PDF · Free to read
The words this page teaches
Each links to its glossary definition, which also names the authority behind it and the components that render it.
- Reasonable compensationThe wages an S corporation must pay a shareholder who works in the business, for that work, before it makes non-wage distributions to them. A C corporation's founder on payroll is an employee too, but the rule is the S corporation's
- FICASocial Security tax — 6.2% of wages up to the year's wage base — and Medicare tax — 1.45% of all wages — each paid twice: withheld from the employee and matched by the employer. 7.65% a side below the wage base
- Payroll liabilitiesWhat an employer owes on wages it has already paid — the income tax and the employees' share of Social Security and Medicare withheld from their pay, plus the employer's own payroll taxes — until it is deposited with the government. The withheld part was never the employer's money: IRS Pub. 15 calls it trust fund taxesConvention