Reasonable Compensation: How the IRS Decides

Training and experience. Duties performed. Time and effort devoted to the business. Comparable salaries for similar roles in similar locations. Dividend (distribution) history. Payments to non-shareholder employees. What an independent third party would pay for the same work.

A written compensation study using a database (RCReports, BLS, industry surveys). A board resolution setting the salary. Consistent year-over-year practice. Adjusting only in audit years is a red flag.

For most owner-operated S-corps in the $150K–$500K profit range, reasonable comp lands between 40% and 60% of net income — though the right number is always job-specific.

Below $150K profit, comp often runs higher as a percentage. Above $500K, comp typically caps at the Social Security wage base plus reasonable Medicare-only wages.

Aggressive salary-to-distribution ratios (e.g., $20K salary against $300K of distributions). No documentation behind the number. Family member 'salaries' that don't reflect actual work. Skipping owner payroll entirely.

If salary has been under-set, a bonus payroll run in December before year-end is the cleanest fix. Going forward, set the next year's comp deliberately, in writing, and run payroll consistently.