Is Your S-Corp Salary Defensible? The Annual Check Every Owner Should Run

An S-corporation owner’s salary should reflect the work they do for the business. But it can be easy to set a number once, move on to the next task, and carry that same figure into future years.

I recommend a simple annual check instead. It gives you a chance to confirm that your pay still fits your role and to keep a clear record of how you reached your decision. This is about maintaining good financial habits, not creating a reason to worry.

Why low salaries can draw attention

S-corporations can pass income through to their shareholders. That does not mean an owner who works in the business can treat all payments as distributions. The IRS says an officer who performs services for the corporation and receives, or is entitled to receive, payment is generally an employee. Payments for those services are generally wages.

The IRS also explains that there is no single formula or fixed amount for reasonable compensation. The circumstances matter, including the work the shareholder performs and what comparable businesses pay for similar services. The IRS can reclassify certain payments to a shareholder-employee as wages.

California has also been part of the recent conversation. At an October 20 webinar, practitioners reported that the state’s Franchise Tax Board and Employment Development Department compare records, including W-2 wages and S-corporation distributions. One example discussed involved an owner who reused a prior-year salary figure. The return was reportedly flagged and led to an adjustment.

That example is a reminder to review your pay as your business and responsibilities change. It is not a salary rule or a reason to assume that a particular figure will trigger a review.

What “reasonable” means

The IRS’s Fact Sheet 2008-25 lists several factors courts have considered when looking at reasonable compensation. For an annual review, I find these three especially useful:

1. Training and experience. What skills, education, credentials, or experience do you bring to the role?

2. Duties and responsibilities. What work do you actually perform? Consider both client-facing or revenue-producing work and management or administrative responsibilities.

3. Time and effort. How much time do you devote to the business, and has that changed?

Then compare your role with independent compensation information. Salary surveys and comparable sources can help you understand how similar work is paid. The Bureau of Labor Statistics Occupational Employment and Wage Statistics is one place to begin. Make sure the comparison fits your occupation and location as closely as possible. A broad job title alone may not reflect the mix of work you do.

Market data is useful context, not an automatic answer. It does not create a universal salary formula, and no single percentage or calculation is guaranteed to fit every S-corporation. The goal is to make a considered decision based on your actual work and keep the reasoning with your records.

A calm annual review in five steps

Choose a regular time for this review. Many owners find it helpful to include it in their year-end bookkeeping or tax-preparation routine.

1. Pull last year’s notes. Review your prior role description, compensation records, and any analysis you kept with the return.

2. Write down what you do now. List your regular duties, responsibilities, and approximate time devoted to the business.

3. Note what changed. Have you taken on new work, managed more people, changed your hours, or shifted from hands-on work to oversight? Record the changes plainly.

4. Check independent market data. Look for comparable pay information that fits your duties and experience. Note the source and the date you accessed it.

5. Document and discuss any adjustment. Keep a short summary of the factors you considered and your conclusion. If your duties or other circumstances point to a different pay level, discuss the appropriate payroll steps with your tax professional before filing.

The file does not need to be complicated. A brief, dated note can capture your role, changes from the prior year, market sources reviewed, and the reason for your decision. Keep it with your tax records so you can find it easily later.

The IRS’s S-corporation compensation guidance also lists other factors, such as payments to non-shareholder employees and compensation agreements. Your tax professional can help you consider the full picture when your situation calls for it.

What about a proposed IRS notice program?

A recent Thomson Reuters report covered comments from an October 20 webinar. The report said a speaker described a possible IRS reasonable-compensation notice program modeled on CP2000 notices. Under the idea discussed, an owner might be asked about the business, their hours, and their duties, and then receive a proposed compensation amount to pay or dispute.

This is a proposal, not a finalized IRS policy or a description of current IRS practice. The webinar speakers also mentioned a possible Form 1120-S checkbox about officer compensation. That, too, was discussed as a proposal, not an existing requirement.

The practical takeaway is straightforward: keep your records current because it helps you explain your decision if questions arise. You do not need to change your process in response to an unfinalized proposal.

The webinar report also included a brief account of a preparer whose examination reportedly expanded to other clients and resulted in preparer penalties. That story is another reason to keep the work professional and documented. It does not change the basic annual habit: review the facts, record your reasoning, and ask for support when you need it.

If you have paid yourself very little for years

Start by gathering your records. Note your duties, hours, compensation, and distributions for the current year. Then speak with your bookkeeper or tax professional before filing.

A long-standing salary does not automatically tell you what to do next. Your current work and business circumstances need to be reviewed. A professional can help you understand the options and how to handle any appropriate change through payroll. Addressing the question now gives you more room to make an informed plan than leaving it until filing is underway.

Keep the habit simple

Reasonable compensation is not a number you can settle for every business by using one formula. It is a decision based on the work you perform, your time and experience, and relevant market information.

I encourage S-corporation owners to revisit that decision once a year. A short review and a clear record can bring your books into better order and make tax preparation smoother. At Jenni’s Business Services, I help small business owners keep their bookkeeping organized and work through tax questions step by step. You can learn more about our bookkeeping and tax services or get in touch to discuss the support you need.