Introduction
If you own an S-Corporation, there’s a good chance you’ve heard the term “reasonable compensation.”
You may have also heard wildly different opinions about what that number should be.
Some say it’s a percentage of profit.
Others say it’s whatever you feel like paying yourself.
And some business owners skip payroll altogether.
The truth? Reasonable compensation isn’t a guess—and getting it wrong can be expensive.
In a recent episode of There’s a Solution for That, Kevin Lacey of Mariner Group broke down what reasonable compensation really means, why it matters, and how S-corp owners can protect themselves.
Let’s demystify it.
What Is Reasonable Compensation?
Reasonable compensation is the salary an S-corp owner must pay themselves for the work they perform in the business.
Here’s the key distinction:
- Salary (W-2 wages) → Subject to payroll taxes
- Distributions (profit/dividends) → Not subject to payroll taxes
Because S-corp profits pass through to your personal tax return (instead of being taxed at the corporate level), there’s a tax advantage built into the structure. But the IRS requires that owners first pay themselves a reasonable salary before taking distributions.
In other words:
You can’t avoid payroll taxes by paying yourself only in distributions.
Why the IRS Cares
If you paid yourself zero salary and took all your income as distributions, you would avoid payroll taxes entirely. That’s exactly what the IRS wants to prevent.
Reasonable compensation ensures:
- You pay payroll taxes on the portion considered wages
- You don’t improperly classify wages as tax-advantaged distributions
Without a documented and supportable salary figure, the IRS can:
- Reclassify distributions as wages
- Assess back payroll taxes
- Add penalties and interest
And once that happens, you’re in a defensive position.
How Is Reasonable Compensation Determined?
This is where many business owners go wrong.
There is no simple percentage formula.
The most defensible approach uses market-based compensation data and evaluates what the owner actually does in the business.
The “Many Hats” Concept
Most small business owners don’t just serve as CEO.
They might also be:
- Salesperson
- Marketing director
- Operations manager
- Project manager
- Bookkeeper
- Strategist
Each role has its own market compensation rate.
A proper evaluation:
- Breaks down the owner’s duties
- Weighs the time spent in each role
- Applies regional compensation data
- Produces a supportable salary figure
This number can vary significantly depending on:
- Geography (San Francisco vs. rural Midwest)
- Industry
- Company size
- Scope of responsibility
The result is not a guess—it’s a documented management assertion supported by compensation databases.
What Happens If You Don’t Address It?
Many S-corp owners:
- Pay themselves too little
- Pay themselves nothing
- Follow outdated advice
- Rely on informal rules of thumb
The problem? If audited, the IRS will perform its own analysis.
And if you don’t have documentation supporting your salary decision, they determine the number—and you must defend yourself.
That could mean:
- Reclassified income
- Back payroll taxes
- Penalties
- Interest
It’s far better to proactively support your position than reactively defend it.
Is It Ever Too Late?
The best time to address reasonable compensation was when you elected S-corp status.
The second-best time is now.
The IRS recommends reviewing reasonable compensation annually. Your role evolves as your business grows, and so should your salary.
Waiting until you receive an audit notice is not a strategy.
Does This Apply to Other Business Structures?
Reasonable compensation is primarily an S-corp issue because:
- S-corp profits pass through to the owner
- Owners can split income between salary and distributions
C-corporations don’t face the same dynamic because corporate income is taxed separately at the corporate level before distributions are made.
If your LLC has elected S-corp taxation, you’re back in this conversation.
Beyond Compliance: A Strategic Perspective
While reasonable compensation is required for compliance, it also serves a strategic purpose.
Using compensation data can help you:
- Benchmark your own pay
- Determine what it would cost to replace yourself
- Plan leadership succession
- Evaluate profit sustainability
It transforms the conversation from “What can I get away with?” to:
“What is this role actually worth in the market?”
Final Takeaway
Reasonable compensation isn’t about minimizing taxes at all costs. It’s about:
- Paying yourself appropriately
- Supporting your tax position
- Protecting your business
- Avoiding unnecessary risk
If you operate as an S-corp and haven’t evaluated your compensation recently, it’s worth revisiting.
Because when it comes to the IRS, unsupported assumptions are rarely a winning strategy.
And in this case, proactive documentation can make all the difference.
