An S corporation owner who works in the business has to be paid a reasonable salary for that work before anything is taken as a distribution. The salary carries payroll tax. The distribution does not. That difference is the entire financial case for the structure, and it is also the reason this is the question with the largest consequences attached to it.
There is no percentage that makes a figure safe. Anyone offering one is offering something that does not exist.
Why the question exists at all
Wages are subject to social security and Medicare tax. Distributions to a shareholder are not.
For 2026 the social security element runs at 6.2 percent from each side on earnings up to a wage base of 184,500 dollars, and the Medicare element runs at 1.45 percent from each side on all earnings with no cap at all.
So every dollar moved from salary to distribution saves that payroll tax, and the incentive to set the salary low is direct, obvious, and immediate. The rules exist because that incentive exists.
Note the asymmetry between the two elements. Above the wage base, the social security saving disappears and only the Medicare element is left, which changes the size of the prize considerably for a high earning owner. Below it, the incentive is at its strongest, which is exactly where the aggressive positions tend to be taken.
How a reasonable figure is actually arrived at
The IRS approach starts from where the money came from. Gross receipts are attributed to:
- Services performed by the shareholder
- Services performed by non shareholder employees
- Capital and equipment
Amounts are wages to the extent they compensate the shareholder’s personal services. Receipts genuinely generated by employees or by capital are a different matter.
That framing is useful, because it explains why two owners with identical profits can have very different reasonable salaries. An owner who personally performs the billable work has most of the receipts attributable to their services. An owner whose fifteen employees do the work, or whose profit comes from equipment, does not.
The factors that inform the figure are the ordinary ones: training and experience, duties and responsibilities, time devoted to the business, dividend history, what comparable businesses pay for comparable work, the timing of bonus payments, compensation agreements, and whether a formula is used.
The practical version: what would it cost to hire somebody to do what you actually do? Evidenced against real comparable pay, and written down at the time rather than reconstructed when asked.
What an unreasonably low salary risks
Distributions can be recharacterised as wages. When that happens:
- Employment taxes become due on the recharacterised amount
- Penalties and interest run on top
- It applies across every open year, not just the one being examined
The IRS has taken this to court and won repeatedly, so this is settled ground rather than a position being tested. The exposure is not a single year’s saving. It is several years of saving, plus penalties, plus interest, arriving together.
The tell that a figure is too low
A salary that is a round fraction of profit, moving with profit rather than with the job.
A real salary is set by what the role is worth and stays broadly stable when profit swings, because the work did not change when the profit did. A figure that is reliably a third of whatever the profit happened to be is describing a tax calculation rather than a wage, and it reads that way to anyone who looks.
The same goes for a salary that appears once in December for the whole year, which is covered in payroll for a one person S corporation.
Document it when you set it, not when you are asked
This is the cheap step that almost nobody takes, and it is the difference between a defensible position and an assertion.
At the point you set the salary, write down what you looked at: the comparable pay data, the duties, the hours, the split of receipts between your work and everything else. A page, dated, kept with the year’s records.
Reconstructing that argument three years later from memory is possible and is worth much less, for the same reason a contemporaneous mileage log is worth more than one written in March.
Before the question even applies
An S corporation has to be available to you. Shareholders may not be partnerships, corporations, or non-resident aliens. This is an eligibility rule rather than a question of whether the structure is a good deal, and it rules the election out entirely for some owners rather than merely making it unattractive.
Whether the structure is right, and what a reasonable figure looks like for the actual work being done, is the kind of decision the entity work exists for.