Running an S Corp comes with perks. One of the biggest? You don’t have to pay self-employment tax on distributions.
But some folks take that and run straight into trouble. They pay themselves a tiny salary, take huge distributions, and think they have outsmarted the IRS.
They haven’t.
If your salary is not “reasonable,” the IRS will reclassify your distributions, slap you with back taxes, add penalties, and remind you they were never playing around.
How the IRS Decides If You’re Underpaying Yourself
They want you to pay yourself what someone else would reasonably earn doing your job. That’s it.
Not what feels fair.
Not what’s leftover after the bills.
Not what you decided based on vibes.
If you’re doing sales, operations, client service, and putting in 40+ hours a week, they expect you to pay yourself like a real employee. Because technically, you are one.
Signs You’re Playing It Too Cute
- You’re taking $100,000 in distributions and paying yourself $10,000 in salary
- You don’t have payroll set up… just transfers marked “owner pay”
- You haven’t increased your salary even though revenue tripled
- You couldn’t explain your pay structure without crossing your fingers
If you couldn’t defend your number with a straight face during an audit, it’s too low.
What Goes Into “Reasonable Compensation”
The IRS considers:
- Your role and how much time you spend in the business
- What others in similar roles and industries make
- The size and profitability of your company
- What you would have to pay someone else to do your job
Most smart S Corp owners pay themselves 30 to 60 percent of net income as salary. The rest comes out as distributions, if the books support it.
What Happens If You Lowball and Get Caught
- The IRS reclassifies your distributions as salary
- You owe back payroll taxes
- They tack on penalties and interest
- You get flagged for future audits
And once they’ve got their foot in the door, they usually keep it there.
Set It Right Before They Set It for You
The best time to fix your salary is now. Before your distributions raise eyebrows. Before you get that letter. Before your tax accountant gives you “the look.”
Need help figuring out what a legit, IRS-proof salary looks like for your role?
Let’s run the numbers and set it right before someone else does it for you.
