Every year, I sit across from smart, successful business owners who made the same mistake. Not because they were careless. Not because they were trying to cheat the system. They followed advice that sounded safe, responsible, and compliant.
“Just pay yourself a reasonable salary.”
That phrase is everywhere. CPAs use it. Payroll providers repeat it. Online forums treat it like gospel. And yet, it’s one of the most misunderstood and dangerous concepts in S-Corp planning.
The problem isn’t that reasonable salary exists. It does. The problem is that most business owners are never taught what it actually means, how the IRS evaluates it, or how easily it can undo an otherwise well-structured tax plan.
This might be a sensitive topic… but I’ve seen it trigger audits. Which in turn often results in back taxes, penalties, and interest years later. I’ve also seen it quietly cost owners six figures in unnecessary payroll taxes because they were overly cautious and under-informed.
This matters because S-Corps are one of the most powerful tax tools available to small and medium-sized businesses. But that power comes with rules. And when those rules are misunderstood, the IRS doesn’t shrug. They correct the record.
Let’s slow this down and unpack what’s really going on.
What “Reasonable Salary” Actually Means Under IRS Rules
Reasonable salary is not a number pulled from thin air. It’s not what feels fair. It’s not what your spouse thinks you should make. And it’s definitely not what your business happened to pay you last year.
From the IRS’s perspective, reasonable salary means this: if someone else were hired to do your job, with your skills, experience, and responsibilities, what would they be paid in the open market?
That definition comes straight out of the Internal Revenue Code and has been reinforced by decades of court cases. The IRS looks at duties performed, time spent, industry norms, geographic location, and the company’s financial performance.
What they do not care about is how much profit is left over after expenses. They also do not care how much you want to save in payroll taxes.
This is where business owners get tripped up.
They hear that S-Corp owners can split income between salary and distributions. That’s true.
Owners also hear that distributions are not subject to payroll taxes. Again, this is also true.
Yet, somewhere along the way, the idea forms that salary should be kept as low as possible. That’s when reasonable salary stops being a compliance standard and starts being a liability.
How S-Corp Owners Actually Pay Themselves
An S-Corp owner wears two hats. One as an employee, and one as an owner. The employee side gets paid a W-2 salary. That salary is subject to payroll taxes. The owner side receives distributions, which are not subject to self-employment tax.
This split is the entire reason S-Corps work so well from a tax standpoint.
But here’s the key point most people miss. The IRS does not allow you to decide which hat earns the income. The work comes first. The salary follows.
If the business’s profits exist because of your labor, expertise, or decision-making, the IRS expects a fair portion of that income to flow through payroll.
I’ve reviewed countless tax returns where the numbers looked clean on paper but failed this basic logic test. One owner was running a professional services firm, handling sales, operations, and delivery, yet paying themselves $40,000 while the business cleared $500,000.
That doesn’t even pass a smell test. And the IRS knows it.
I’ve written an article on how to determine reasonable salary… you can find it here.
Why This Is So Different From How an LLC Owner Gets Paid
This confusion often comes from how LLCs are taxed.
A single-member LLC, by default, doesn’t pay the owner a salary. The owner takes draws. All net profit is subject to self-employment tax, whether the money is withdrawn or not. There is no salary versus distribution distinction.
That’s painful from a tax standpoint, but simple from a compliance standpoint. The IRS gets paid either way.
S-Corps flip that dynamic. They introduce flexibility. Flexibility is great, but it also invites scrutiny.
When someone moves from an LLC to an S-Corp, they often carry over old habits. They assume they can “take draws” the same way. They assume payroll is optional. Or they assume any number will work as long as it’s defensible.
The IRS treats those assumptions as mistakes.
The Audit Risk Is Real, and It’s Documented
This isn’t hypothetical. The IRS has been clear about where they focus enforcement.
According to IRS data and enforcement summaries tied to employment tax audits, S-Corps are disproportionately examined for compensation issues. Reasonable salary is one of the most common adjustment triggers.
Having spoken with several former IRS agents over the years — the biggest comment I hear over and over is:
“Owners have no basis for WHY they have selected a specific salary. Instead of using a reputable service to determine the salary, in some weird way they just either pick a percentage or a “ghost” number they feel comfortable with. Either of those processes have any substantiation of what a true replacement cost is… and that is generally why the owner loses the battle with the IRS.”
IRS Publication 55 and related enforcement guidance outline how payroll tax compliance remains a top audit priority, especially for closely held businesses where owners control both pay decisions and profit distributions.
When the IRS challenges reasonable salary, they don’t just adjust future years. They reclassify past distributions as wages. That triggers back payroll taxes, penalties for failure to withhold, and interest that compounds quickly.
I’ve walked clients through these cleanups. They’re not fun. The worst part is that they are completely avoidable.
Why “Conservative” Can Be Just as Dangerous as Aggressive
Here’s the part that surprises most people.
Paying yourself too little is risky. But paying yourself too much can be just as damaging, just in a quieter way. I’ve seen owners pay themselves high six-figure salaries out of fear. Their accountant told them,
“Let’s stay safe.”
The result was tens of thousands of dollars in unnecessary payroll taxes every year.
That money could have gone toward retirement plans, hiring, debt reduction, or investment. Instead, it went to the government because no one bothered to calculate the correct number.
Reasonable salary is not about minimizing taxes at all costs. It’s about precision. Getting the number right protects you on both sides of the equation.
How the IRS Thinks About Your Role in the Business
When the IRS evaluates compensation, they don’t care about titles. They care about function.
If you are the rainmaker, they expect market-level compensation for sales leadership. Or, if you are the technical expert, they expect pay consistent with that expertise. Even if you are “just” managing people, operations, and strategy, they stack those roles together.
This is why generic benchmarks fail. A national average doesn’t account for what you actually do day to day.
In my own work, I start by mapping responsibilities. Then I look at comparable roles, adjusted for geography and company size. To add another layer of defensibility… we take these and plug them into a reputable software, which sole purpose is to track salaries based on title, work, and location — and it gives us an accurate number of what your reasonable compensation should be.
And to be clear, this isn’t opinion or industry folklore. This is the exact data the IRS uses in its own reasonable salary analysis. Imagine how much they can argue if you bring this to the auditing table?
This process is exactly what I walk through in detail in my separate article on setting reasonable salary, which I strongly recommend reading before making any payroll changes.
Why Documentation Matters More Than the Number
Here’s something most CPAs never tell you.
In an audit, the IRS is not just judging the salary. They’re judging the decision-making process.
If you can show how the number was determined, what data was used, and why it makes sense given your role, the conversation changes. Auditors are trained to look for intent and consistency.
When the number exists because “that’s what we’ve always done,” you’re exposed. When the number exists because it was calculated and reviewed, you’re protected.
This is where strategic planning separates itself from compliance.
The Quiet Interaction With Retirement, Healthcare, and Benefits
Reasonable salary doesn’t exist in a vacuum.
Your salary affects how much you can contribute to retirement plans. It affects how health insurance is deducted. It affects disability coverage, Social Security credits, and even loan underwriting.
I’ve seen owners optimize salary for tax savings and accidentally cap their retirement contributions. I’ve seen others inflate salary and lose flexibility elsewhere.
This is why reasonable salary should never be set in isolation. It has to fit into the broader picture of cash flow, benefits, and long-term planning.
Why Most Online Advice Gets This Wrong
The internet loves shortcuts.
“Pay yourself 30 percent, keep salary under $100,000, take the rest as distributions.”
Those rules of thumb are dangerous because they ignore context. They also create false confidence.
The IRS doesn’t audit based on percentages. They audit based on facts.
If your business doubles in size and your salary stays flat, that’s a red flag. If your role evolves and your pay doesn’t, that’s another one.
Static rules don’t survive dynamic businesses.
The Real Cost of Getting This Wrong
When reasonable salary is mishandled, the damage often shows up years later. By the time the IRS sends a notice, the money is already spent. The distributions are gone. The tax bill isn’t.
What makes this frustrating is that most of these situations could have been avoided with a single proactive conversation.
I’ve built my practice around preventing these moments. Not by pushing the envelope, but by understanding where it actually is.
Bringing It All Together
Reasonable salary is not a box to check. It’s not a guess. And it’s not something to outsource blindly.
It sits at the intersection of tax law, economics, and reality. When handled correctly, it protects you. But when it is handled casually, it invites scrutiny. Always remember this: S-Corps are powerful! But power without understanding and the right guidance is risky.
If you’re an S-Corp owner and haven’t revisited your salary recently, or if your number was chosen without analysis, it’s worth a closer look. Not because you’re doing something wrong, but because the cost of being wrong is too high to ignore.
Welcome to the New Age of Accounting. Let’s begin.
P.S. If you found this article helpful, you’ll love my new book S-Corp Mastery: How Smart Business Owners Maximize Tax Savings & Build a Lasting Legacy. It’s now live and available in a sleek, easy-to-read PDF version. Grab your copy here
Chris is the Managing Partner at Weston Tax Associates, a best-selling author, and a renowned tax strategist. With over 20 years of expertise in tax and corporate finance, he simplifies complex tax concepts into actionable strategies that drive business growth. Originally from Sweden, he now lives in Florida with his wife and two sons.
