Reasonable Compensation for S-Corp Owners: How to Set Your Salary

Every S-Corp owner who performs services for the business must receive reasonable compensation (a W-2 salary) before taking any distributions. This is not optional. The IRS has won court cases on this issue, such as David E. Watson P.C. v. United States (2012) and Sean McAlary Ltd. Inc. v. Commissioner (2013). The consequence of paying too little (or no) salary is reclassification of distributions as wages, plus back employer FICA (7.65%), back employee FICA (7.65%), penalties, and interest. The question is not whether to pay a salary, but how much. The answer depends on the owner’s role, the industry, hours worked, and what comparable businesses pay for similar services.

How do you determine the right salary?

How does the IRS judge an HVAC owner’s S-Corp salary?

The IRS starts with what you actually did for the company. Its guidance says the key to reasonable compensation is looking at the source of the S-Corp’s gross receipts: your own services, work by non-shareholder employees, or capital and equipment. For an HVAC owner who runs calls, sells jobs and keeps the books, much of that points back to the owner’s own work.

From there, courts have weighed factors the IRS lists: training and experience, duties, time and effort, dividend history, pay to non-shareholder employees, timing and manner of bonuses to key people, what comparable businesses pay for similar services, compensation agreements, and use of a formula. The IRS doesn’t weight them, and none of them is a salary table.

The Code and regulations give no specific guideline for the number. In Watson, comparisons with what similar professionals earned were part of the evidence, but no document works as a safe harbor. If the IRS decides the salary was too low, it can reclassify distributions as wages and collect the payroll tax.

What are the most common IRS audit triggers for small businesses?

Schedule C filers with high gross receipts and significant deductions relative to income are audited at higher rates. Specific triggers include: claiming 100% business use of a vehicle, large home office deductions relative to income, cash-intensive businesses with round-number reporting, significant charitable deductions relative to income, and repeated business losses (hobby loss rule after 3-5 years). Inconsistencies between information returns (1099s, W-2s) and your reported income generate automatic notices. High deduction-to-income ratios compared to industry averages from the IRS’s DIF (Discriminant Information Function) scoring are a primary selection criterion. An audit does not mean you did anything wrong; it means your return was statistically unusual.

Related guides:

• Reasonable Compensation for S-Corp Owners: How the IRS Determines Your Salary
• S-Corp Reasonable Compensation: How the IRS Determines Your Salary and What H…
• S-Corp Reasonable Compensation: How to Set Your Owner Salary

How long does the IRS have to audit your tax return?

The standard statute of limitations for an IRS audit is three years from the date you filed your return or the due date, whichever is later, under IRC 6501(a). This extends to six years if you omit more than 25% of gross income from your return, which the IRS interprets broadly to include overstatements of basis in some circumstances after the Supreme Court’s Home Concrete decision. There is no statute of limitations for fraudulent returns or for returns that were never filed, meaning the IRS can audit these at any time. Signing a Form 872 (Consent to Extend the Time to Assess Tax) extends the deadline, and the IRS often requests this near the end of the three-year window to continue an open examination without rushing to closure.

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.