The number one question I get from business owners who form an S-Corp is: “How much should I pay myself?” And for good reason. Paying yourself the wrong salary can trigger IRS scrutiny, leading to audits, penalties, and unnecessary headaches.
This isn’t just a theoretical concern. It happens every year to unsuspecting business owners who either don’t take a salary at all (bad idea) or try to game the system with an arbitrarily low payroll amount while maximizing distributions (worse idea).
I want to add a quick disclaimer here: while this article discusses various audit risks and IRS scrutiny, it’s important to note that the overall risk of being audited remains extremely low for most taxpayers. This risk is even lower for properly structured and operated S-Corps. These references are not meant to instill fear, but to promote awareness and proactive planning. In my experience, the best audit defense is simply doing things right from the start. That begins with understanding the rules and having proper documentation should the issue arise.
Now, with all that legal mumbo jumbo out of the way… let’s break it down so you can get it right the first time.
Understanding S-Corp Payroll: W-2 Salary vs. Distributions
Unlike an LLC or sole proprietorship, where all business profits flow directly to the owner, an S-Corp owner must take a salary. This is non-negotiable. The IRS expects that if you work in the business, you pay yourself a “reasonable compensation” before taking any additional profits as distributions.
Here’s the basic framework:
- Your salary (W-2 wages) is subject to payroll taxes (Social Security and Medicare).
- Your distributions (the remaining profit you take out) are not subject to payroll taxes.
That’s the primary tax advantage of an S-Corp. However, if you try to game the system by taking an unreasonably low salary and maxing out your distributions, you’re inviting trouble.
The Wrong Way to Calculate Reasonable Compensation
Some online “gurus” push the idea that reasonable compensation should be based on a percentage – like 40% salary and 60% distributions. Others suggest using an arbitrary matrix based on revenue.
This approach is wrong and risky.
The IRS doesn’t use a fixed percentage or a one-size-fits-all formula. Instead, they examine industry norms, geographical location, experience level, and what a similar employee would be paid in the open market.
If you set your salary using a generic matrix and the IRS challenges it, what proof do you have that your number is valid? “I saw it on a blog” will not hold up in an audit.
How to Determine the Right Salary
The smartest way to calculate reasonable compensation is by using a reputable payroll service or compensation analysis firm. These companies provide reports based on real data, industry-specific salary trends, geographic cost-of-living adjustments, and comparable wages for similar roles.
Here’s what you should do:
- Hire a third-party firm to generate a reasonable compensation report. These reports compile IRS-accepted data and show what someone in your position, with your experience, should be making.
- Pay yourself what the report recommends. If the data says you should be making $85,000 a year, don’t try to justify taking only $30,000.
- Document everything. Keep the report in your records so you can defend your salary if the IRS ever comes knocking.
When setting your compensation, the company running the report will ask about your day-to-day activities. For example, an accountant doesn’t just do tax returns or QuickBooks entries all day. They also run their business, handle marketing, set up calls, pay bills, and focus on business development. Each of these functions makes up a percentage of how much time you spend on each activity.
While you’ll need to estimate, the key is to recognize that you’re not doing just one role all day, every day. Each function comes with what the IRS refers to as a replacement cost… if you hired someone else to perform these tasks, what would their salary be?
Industry-standard wages for each activity are multiplied by the estimated hours spent, ultimately forming the basis of your reasonable compensation.
For example, let’s say you’re a CPA running your own tax practice. You estimate your time as follows:
- 50% tax preparation and accounting (industry wage: $25.59/hour)
- 20% client meetings and consultations (industry wage: $41.13/hour)
- 15% marketing and business development (industry wage: $23.84/hour)
- 15% administrative tasks and payroll (industry wage: $18.23/hour)
If you work 2,000 hours a year, your compensation calculation would look like this:
(1,000 hours x $25.59) + (400 hours x $41.13) + (300 hours x $23.84) + (300 hours x $18.23) = $54,663 is the reasonable compensation. The report itself would look something like this:
By following this approach, you have a defendable, data-backed salary that aligns with IRS guidelines.
What Happens If You Don’t Follow the Report?
Let’s say your compensation report suggests a salary of $54,663 (as shown above). Don’t pay yourself $55,000 just because an even number seems more logical or easier to administer. Remember, if you tell your payroll company to pay you a specific number (no matter how specific), they’ll handle the calculations.
If you decide to go against my advice… here’s how this could come back and haunt you:
- The IRS can reclassify some or all of your distributions as W-2 wages, meaning you owe back payroll taxes, penalties, and interest.
- If you’re audited and you don’t have proper documentation backing up your salary decision, you’re handing the IRS an easy win.
- Even if you think your “reasonable” number makes sense, deviating from a professionally prepared report just gives the IRS another reason to argue against you.
- Finally, why would you spend the money of preparing this report if you’re not going to use it to your benefit anyways?
It’s not worth the risk.
Why This is a Top IRS Audit Trigger
The IRS actively looks for S-Corp owners who underpay themselves. Why? Because payroll taxes are a major revenue stream, and if they suspect you’re skirting the rules, you’re an easy audit target.
In fact, a recent IRS audit report found that S-Corp owners underpaying themselves is one of the most common compliance issues. The government loses billions in unpaid payroll taxes every year due to this practice… so they’re cracking down harder than ever.
The easiest way to avoid becoming a target? Pay yourself correctly and keep the documentation to prove it.
Final Thoughts
Running an S-Corp has massive tax advantages, but only if you do it right. Taking an artificially low salary might feel like a tax-saving strategy – until the IRS steps in and reverses your distributions, slaps you with back taxes, and makes you wish you had just done things properly from the start.
Protect yourself. Get a legitimate compensation analysis. Pay yourself accordingly. Keep records. Hire a payroll company to do it for you… it is not cheap, yet maybe the cheapest insurance policy you can buy each year. It’s not a difficult process and is all handled online. That’s how you stay compliant and keep your S-Corp running smoothly.
If you have further questions… feel free to book a consultation with us to discuss your future.
Welcome to the New Age of Accounting. Let’s begin.
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.
