Forming an S-Corporation opens the door to significant tax advantages, particularly the ability to avoid self-employment tax on business profits distributed to shareholders.

However, this benefit comes with an important condition: if you actively work in the business, the IRS requires you to pay yourself a reasonable salary before taking distributions. Failing to meet this requirement—or setting your salary too low—can lead to audits, penalties, back taxes, and even the loss of your S-Corp status.

If you’re interested in the other factors to consider when starting an S-Corporation, check out The S-Corp Question.

The Advantage & the Catch

S-Corporations pass income straight through to their shareholders, sparing that money from the 15.3 percent self‑employment tax that sole proprietors and partners pay on every dollar of business profit.

The IRS is aware of the tax avoidance benefits of the S-Corporation, so there’s a catch. The IRS requires S-Corp shareholders to receive “reasonable compensation” for the services they perform.

Reasonable compensation must be formed on the Form W-2, and is subject to FICA taxes. Half of FICA taxes are paid and deducted by the S-Corporation, and the other half are withheld from the officer’s paycheck.

Failure to pay reasonable compensation may result in the IRS reclassifying some of your distributions as wages. This can result in additional taxes, interest, and penalties.

What Does “Reasonable Compensation” Mean?

“Reasonable” sounds subjective because it is. There is no magic percentage of revenue or profit that automatically satisfies the rule.

Instead, the Tax Court looks at familiar, commonsense markers: training and experience, the scope of your duties, how many hours you pour into the operation, and what similar businesses pay for comparable roles in the same region.

Think of it as hiring your own replacement. For example, if an S-Corp shareholder bookkeeper determines it would cost $95,000 to hire a replacement, $95,000 becomes the benchmark.

Building a Defensible Compensation Figure

Because “reasonable” is movable, documentation is everything. Third‑party compensation studies, such as RCReports, compile labor‑market data by geography, industry, and job description.

Pair that data with an internal breakdown of your tasks and the weekly hours you devote to each. The more granular your narrative, the easier it is to defend during an audit. Revisiting the figure each year is wise, especially if your role or the market shifts.

Health Insurance Premiums

One elegant way to reduce payroll tax without skimping on your salary is to let the S corporation pick up the tab for your medical insurance.

Premiums the company pays on behalf of a shareholder‑employee go on line 1 of your Form W‑2, boosting taxable wages for income‑tax purposes. However, these amounts are not subject to FICA tax, meaning we are avoiding that 15.3 percent total tax.

On your personal return you then deduct those same premiums “above the line.” The result is legitimate wage income for compensation purposes, a paper trail the IRS likes, and a bit of FICA avoidance.

Reasonable Compensation < Net Income?

One exception to the “reasonable compensation” rule is if your business has less income than your reasonable compensation. Your compensation can be the lesser of what you might have calculated as reasonable or your net business income. Otherwise, you would end up paying FICA tax on more income than your business actually earned.

This is not an ideal scenario and indicates that operating as an S-Corporation may be to your detriment!

Putting It All Together

Choosing a reasonable compensation figure is less about chasing a single perfect number and more about building a story you can prove: a salary that tracks the market, a log of the work you perform, and periodic reviews as the business matures.

The rules can be nuanced, so involve your accountant early, keep your documentation tidy, and you’ll enjoy the S corporation’s tax perks with far less stress.