How is reasonable salary set for an S-Corp owner?

Reasonable salary is what your company would have to pay someone else to do the work you do, at arm's length, in your market. That's the standard. There is no percentage, no ratio and no IRS formula.

The "60/40 rule" isn't in the Code, the regulations or any IRS guidance. The number that holds up is one you can trace to your duties, your hours and market wage data, written down before anyone asks.

Who this applies to

• Owners of S corporations, including LLCs taxed as S-Corps, who work in the business and take money out of it.
• Owners who just elected and are setting a salary for the first time, or owners who picked a number years ago and never revisited it.
• Multi-owner S-Corps where owners work different amounts. Each working owner needs a salary that fits their own role.

Who it doesn't

• Sole proprietors, single-member LLCs that haven't elected S status, and partnerships. There's no owner salary there; self-employment tax generally applies to the profit instead.
• S-Corp shareholders who do no more than minor work for the company and receive no pay for it. According to the IRS, courts have held that shareholder-officers are employees when they do more than minor services and receive, or are entitled to receive, pay.
• C corporations. The same "reasonable" standard applies, but the usual audit question there runs the other way: whether pay is too high to deduct.

What does "reasonable" actually mean?

The IRS says an S-Corp must pay reasonable compensation to a shareholder-employee for services before making non-wage distributions. If it doesn't, the IRS can reclassify distributions as wages subject to employment taxes. The Form 1120-S instructions say the same: payments to a corporate officer are wages to the extent they are reasonable pay for services.

The benchmark comes from the income tax regulations: what "would ordinarily be paid for like services by like enterprises under like circumstances" (Treas. Reg. 1.162-7(b)(3)). Put plainly, what would a similar business pay a non-owner to do your job?

The IRS lists the factors courts weigh:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• Use of a formula to determine compensation

Where your company's income comes from matters

The IRS frames the key question as what the shareholder did for the S-Corp, and it points to the source of the company's gross receipts. Receipts come from three places: your own services, the work of non-owner employees, and capital and equipment.

If nearly all the revenue is you, personally doing the work, most of the profit looks like pay for your services. A solo consultant or agent has less room between salary and profit than an owner whose staff and equipment generate much of the revenue.

That's the real reason the 60/40 split fails. It ignores where the money comes from.

How do you find the number?

The IRS's own job aid for its valuation staff describes three approaches. It's a 2014 internal reference, not official IRS position, but it shows how an examiner can build a counter-number.

1. Market approach. Compare your pay to what non-owners in the same role earn at similar companies. The job aid calls this the most commonly used method, and says the final answer generally rests heavily on it.
2. Cost approach. Break your year into the jobs you actually do (client work, sales, bookkeeping, management), price each with salary data, and weight each by the share of your time it takes. The job aid warns against adding up several full-time salaries, because you only have one set of hours.
3. Income approach. Asks whether an outside investor would be satisfied with the return left after your pay. It needs a value for the business each year, which is why it's rarely the main tool for a small company.

For most owner-operated service businesses, the work is a market approach, with a time-weighted blend when you wear several hats.

Where does the wage data come from?

The Bureau of Labor Statistics Occupational Employment and Wage Statistics (OEWS) program publishes wage estimates for roughly 830 occupations, nationally, by state and by metro area. The most recent release covers May 2025.

Industry salary surveys and trade association data are also used. In Watson, one of the court cases the IRS cites on this issue, the government's expert relied mainly on an AICPA survey of accounting firm pay.

Whatever source you use, record the occupation, the area, the data year and why it matches your role.

What happens if the salary is too low?

A clear example is David E. Watson, P.C. v. United States (8th Cir. 2012). Watson, a CPA with an advanced degree and nearly 20 years of experience, paid himself $24,000 a year through his S-Corp in 2002 and 2003. In those same years, through the S-Corp, he received $203,651 and $175,470 in profit distributions from his accounting firm.

The government's expert used accounting firm survey data to value his services at $91,044 a year. The district court adopted that figure, treated the $67,044 gap each year as wages, and entered a judgment of $23,431.23 in employment taxes, penalties and interest. The Eighth Circuit affirmed.

Two details matter for any owner. There were no documents showing how the $24,000 was set, and the court found the claim that it was the intended pay less than credible.

A worked example

How it changes for an S-Corp owner

As a sole proprietor, there's no salary decision: self-employment tax applies to your net profit as a whole. The S-Corp election creates the split, and the split is the entire source of the payroll tax savings, as the break-even math shows.

That makes salary the number most likely to be questioned. It also feeds other numbers: your Social Security and Medicare tax, your retirement contributions and your qualified business income (QBI) deduction. Reasonable compensation isn't QBI under section 199A(c)(4).

Above the 2026 threshold of $201,750 of taxable income ($403,500 married filing jointly), limits phase in over the next $75,000 ($150,000 joint): the deduction can be capped by W-2 wages paid, so salary can help or hurt. For a specified service business, which includes consulting, the deduction itself phases out over that range. See how S-Corp salary affects the QBI deduction.

How should you document it?

The IRS job aid tells examiners to ask whether the company keeps contemporaneous records of how pay was set, and whether salary surveys were used. Build the file before you need it:

• A short job description and an estimate of hours by type of work.
• The wage data you used, with source, occupation, area and year.
• The calculation, and a written approval by the company, such as a board or shareholder consent.
• An annual review. Duties, hours and the market change, and so should the number.

Then pay it. Salary runs through payroll with withholding and a W-2, on a regular schedule, not as a December plug. Year-end moves for S-Corp owners covers closing a gap before December 31, and the post-election checklist covers the rest of the setup.

The bottom line

A reasonable salary is a market wage for the work you actually do, adjusted for your time, and written down. The 60/40 split is a guess that can overpay or underpay.

Too low, and the IRS can recast distributions as wages with tax, penalties and interest. Too high, and you've paid payroll tax the election was meant to save.

If you want the number built and documented for your role, the free 20-minute intro call is the place to start.