Your S-Corp Salary Is Probably Wrong: Here's the Number the IRS Actually Expects
Every S-corporation owner I’ve ever sat across from has the same quiet anxiety: am I paying myself the right salary?
It’s a question that should have a simple answer. It doesn’t. And the IRS has built an entire enforcement program around the fact that most owners get it wrong, usually in the direction of paying themselves too little.
If you own an S-corp doing somewhere between $1M and $10M in revenue, this post is for you. By the end of it, you should know exactly how the IRS thinks about reasonable compensation, what the case law actually says, and how to land on a number that survives an audit.
Why This Matters More Than Most Owners Realize
Here’s the mechanic, in case you’ve forgotten why anyone cares: in an S-corp, the money you take out as salary is hit with payroll taxes — 15.3% on the first $176,100 (the 2025 Social Security wage base, indexed up for 2026), then 2.9% Medicare with no cap, plus 0.9% Additional Medicare above $200K.
The money you take out as a distribution is not.
That creates an obvious temptation: pay yourself a tiny salary, take everything else as a distribution, and save a fortune in payroll taxes.
The IRS knows this. It’s been one of their top enforcement priorities for over a decade. When they win — which they do — they reclassify your distributions as wages, back-assess payroll taxes, slap on penalties, and add interest.
I’ve seen six-figure assessments on what started as routine audits.
Why Your Salary Number Affects More Than Just Payroll Tax
Reasonable compensation isn’t just about audit risk anymore. It also drives the size of your Section 199A Qualified Business Income (QBI) deduction, the 20% deduction for pass-through business income, in two important ways.
First, the deduction is calculated on your QBI, which is your business income after deducting reasonable compensation. The higher your salary, the lower your QBI, and the smaller your QBI deduction becomes. That cuts in favor of keeping salary low.
Second, for higher-income owners, the QBI deduction is capped at the greater of:
- 50% of W-2 wages paid by the business
- Or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property
The net effect: your S-corp salary has to be optimized against the QBI deduction as well as the IRS’s reasonable compensation rules.
It’s no longer just “what number won’t get me audited?” It’s “what number actually maximizes my after-tax outcome?”
And the answer is different for almost every client.
What the Case Law Actually Says
Most CPAs will tell you to “pay yourself a reasonable salary.”
Useful as a fortune cookie. Less useful as guidance.
The real framework comes from two cases every S-corp owner should know:
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Watson v. Commissioner (8th Cir. 2012)
David Watson was a CPA who paid himself $24,000 in salary while his S-corp distributed him roughly $200,000 a year. The IRS reclassified $67,000 of his distributions as wages, and the court agreed. The takeaway: a $24K salary for a professional service provider clearing six figures was indefensible. -
Glass Blocks Unlimited v. Commissioner (T.C. Memo 2013-180)
The owner paid himself $0 in wages while taking distributions and loan repayments. The Tax Court reclassified $30,000 as wages. The clear rule: if you’re materially participating and the business is profitable, your wage cannot be zero.
The combined principle from these cases is simple:
Your salary has to reflect what you’d pay someone else to do your job.
Not what’s convenient. Not what minimizes tax. What the market would charge for the work you’re actually performing.
The Framework I Use With Clients
When we set reasonable compensation at Shahbaz & Associates, we work through five factors. The IRS uses substantially the same list in its own guidance.
-
What does the role actually do?
A $4M HVAC company owner who runs operations, sells, and handles bidding is doing multiple jobs. We document each one separately. -
What does the market pay for that role?
We pull data from the Bureau of Labor Statistics, RCReports, Salary.com, and industry surveys.
For a general manager of a $4M services business, this is often $95K–$145K in 2026. A CEO-owner handling sales may add $40K–$70K. -
What are the owner’s credentials and experience?
Tenure and expertise matter. A 20-year operator is not priced like a new entrant. -
How much time is the owner actually spending?
Full-time vs part-time changes everything. -
What does the business actually earn?
Compensation cannot exceed what the business can realistically support.
We document this in a memo, keep it in the file, and refresh it every two to three years.
If the IRS ever questions it, we can defend the number with evidence, not opinion.
A Rough Benchmark — But Only a Rough One
If you want a starting point before doing the full analysis:
-
Service businesses (consulting, professional services):
40–60% of net profit before owner compensation -
Trades and contracting businesses:
30–50% of net profit before owner compensation -
Product businesses (e-commerce, distribution):
25–40% of net profit before owner compensation
These are directional only. The real number depends on the full five-factor analysis and QBI interaction.
What To Do This Week
If you’re not sure your salary is defensible:
First, compare your W-2 to your K-1 distributions. If salary is less than one-third of distributions, you’re in a higher-risk zone.
Second, list everything you do in the business each week. Sales, operations, hiring, strategy. Then ask what it would cost to replace you.
Third, get a second opinion. Many S-corp salaries are set once and never revisited, which is where risk quietly builds.
The Bottom Line
Reasonable compensation is no longer just a payroll tax issue.
For S-corp owners in 2026, it sits at the intersection of:
- IRS audit risk
- Payroll tax exposure
- QBI deduction optimization
- Overall tax efficiency
Getting it wrong can be expensive. Getting it right can materially improve after-tax outcomes while keeping your structure defensible.
At Shahbaz & Associates CPAs, we help S-corp owners evaluate reasonable compensation using IRS guidance, market data, and tax modeling.
If you want to know whether your salary is defensible and whether your QBI deduction is optimized, we can help you run the numbers properly.