Reasonable Compensation: The S-Corp Rule With No Number Attached

The S-Corp saving is real. Profit taken as a distribution is not subject to self-employment tax, while salary is. The temptation is obvious: pay a small salary, take the rest as distribution.

The rule limiting that is called reasonable compensation, and it is unusual because the IRS has never published a number.

Why there is no percentage

People repeat rules of thumb like a 60/40 split between salary and distribution. None of these come from the IRS. They are conventions, and a convention is not a defence.

What the standard actually asks is what you would have to pay someone else to do your job. That is a fact about your role and your market, not a fraction of your profit.

What actually gets weighed

The factors that matter are your duties and hours, your training and experience, what comparable roles pay in your industry and location, how much of the profit is attributable to your personal work rather than to capital or staff, and what the company pays everyone else.

A sole owner doing all the billable work in a service business sits at the difficult end of that list. Almost all the profit traces back to their own labour, which makes a low salary hard to justify.

The cost of getting it wrong

If the salary is found to be unreasonably low, distributions get recharacterised as wages. That brings back the employment tax, plus interest and potentially penalties, across every open year rather than just the one being examined.

Because it compounds across years, this is usually a far larger number than the tax originally saved.

Document it when you set it, not when you are asked

A defensible figure comes with evidence: salary survey data for your role and region, a note of your hours and responsibilities, and a record of the reasoning. Gathered at the time, that takes an hour. Reconstructed under examination three years later, it rarely convinces.

This is also the point where the election stops being worth it for smaller profits, because a defensible salary leaves little left to distribute.

How Exemplary Helps

Exemplary sets the salary figure from comparable market data and documents the basis for it in the same year it is set, so the number has support behind it if it is ever questioned.

The saving is only a saving if it survives review.