Quick answer: Reasonable compensation is the salary the IRS requires S-corp shareholders who work in the business to pay themselves. It must reflect what a third-party employer would pay for the same services. There is no fixed formula — it's based on your role, industry, experience, and local market rates. Paying an artificially low salary to funnel more income through untaxed distributions is one of the IRS's top S-corp audit triggers.
How the IRS Determines "Reasonable"
The IRS looks at multiple factors when auditing S-corp compensation: comparable salaries for the same position in your industry and region (BLS.gov data, salary surveys), the time and effort devoted to the business, training and experience, duties and responsibilities, and the overall financial condition of the business. A general contractor with $400,000 in net profit paying himself $30,000 per year will get scrutinized — a regional market salary for that role might be $80,000–$120,000. Courts have generally upheld the "replacement cost" method: what would you have to pay someone to do exactly what you do?
Practical Ranges by Income Level
While there's no universal rule, many CPAs use these rough guidelines: if your S-corp has $80,000–$120,000 in profit, a salary of $50,000–$70,000 is often defensible. At $200,000 in profit, salaries of $80,000–$120,000 are common. At $500,000+, salaries in the $120,000–$180,000 range are typical for single-owner service businesses. Some practitioners use a salary-to-distribution ratio of 50–60% salary as a conservative baseline. The key is documenting your reasoning — reference Bureau of Labor Statistics data, industry salary surveys (Robert Half, SHRM), or a formal compensation study.
Consequences of Getting It Wrong
If the IRS audits and reclassifies distributions as wages, you'll owe back payroll taxes, a 100% trust fund penalty on the employer portion, plus interest and potentially accuracy penalties — sometimes a bill 2–3 times the original tax savings. Courts have sided with the IRS in cases where owner-employees paid themselves $0 in salary (Watson v. Commissioner, 2012). The fix is not complicated: work with a CPA to set a defensible salary, document your reasoning each year, and adjust as the business grows. The tax savings from a properly run S-corp are real and legal — just don't abuse the structure.
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