Electing S Corporation status is a powerful way to reduce self-employment taxes, yet many owners still overpay each year. The issue is rarely noncompliance. More often, it is caution. Concern about the IRS leads many S Corp owners to set their salaries higher than necessary, which results in avoidable payroll taxes without any real benefit.
Below is a practical look at what the IRS actually expects and how to set a salary that is compliant, defensible, and tax-efficient.
What the IRS Actually Expects from S Corp Owner Salaries
If you own an S Corporation and actively work in the business, the IRS requires one thing before you take distributions:
You must pay yourself a reasonable salary for the services you perform.
That salary:
- Is paid through payroll
- Reported on a W-2
- Subject to Social Security and Medicare taxes
What the IRS does not do is set a fixed number or percentage. There’s no official minimum, no safe-harbor rate, and no universal formula.
Instead, compensation is evaluated based on facts and circumstances, including what you do, how much you work, and what the market would pay for similar services.
Why Paying Yourself Too Much Can Be a Costly Mistake
Let’s look at a simple example.
Assume your S Corp earns $250,000 in net income for the year. To play it safe, you decide to pay yourself a $160,000 salary, with the remaining profit taken as distributions.
Here’s what that decision leads to:
- Payroll taxes apply to a much larger portion of your income
- You may be overpaying $8,000 to $12,000 per year in unnecessary taxes
- Less cash is available for reinvestment, savings, or long-term planning
Now compare that to a more strategic approach.
If your salary is set at $65,000, supported by proper compensation analysis, the remaining profits can be taken as distributions. The result is:
- The same level of compliance
- Lower overall tax cost
- Stronger cash flow
The difference isn’t about taking more risk, It’s about using the S Corp structure strategically.
What If You Didn’t Take Any Distributions?
A common question S Corp owners ask is:
“If I didn’t take distributions and left the money in the business, do I still need to pay myself a salary?”
In most cases, yes.
The IRS does not base the salary requirement on distributions. It focuses on whether you provided services to the company.
If you’re:
- Managing operations
- Generating revenue
- Making business decisions
Then reasonable compensation is required, even if:
- Profits stay in the business
- Earnings are retained or booked as APIC
- No cash was withdrawn
The only real exception is a truly inactive shareholder, which is rare in small businesses.
Is the “30% Rule” a Real IRS Requirement?
You’ve probably heard that your salary should be “at least 30%” of profits.
That figure is not an IRS rule.
The IRS has never published a required percentage. The idea likely came from:
- Tax court cases
- CPA heuristics
- Informal industry norms
Percentages can be useful reference points, but they don’t hold up on their own in an audit. What matters is whether the number is supportable based on your role and market data.
How the IRS Evaluates Reasonable Compensation
When reviewing S Corp salaries, the IRS considers factors such as:
- Your duties and responsibilities
- Time devoted to the business
- Compensation paid for similar roles in similar businesses
- Your experience and qualifications
- The company’s revenue and profitability
- Any compensation agreements
- Use of corporate assets
These factors come directly from IRS guidance and tax court precedent, they’re not theoretical.
How to Defend Your Salary If the IRS Ever Asks
Reasonable compensation isn’t about guessing or picking a conservative number. It’s about documentation and support.
A defensible salary typically reflects:
- Industry and geographic data
- Market-based wage comparisons
- Your actual role breakdown (strategic vs. operational vs. administrative)
- The size and performance of your business
Whether through third-party salary data, formal compensation studies, or professional analysis, the goal is the same:
To clearly justify why your salary makes sense.
At Taxfully, we focus on ensuring your salary is defensible, so you’re not overpaying taxes out of fear, and you’re never exposed due to underpayment.
Finding the Right Balance: Compliance Without Overpaying
The goal isn’t to pay yourself the lowest salary possible.
And it’s not to overpay just to feel safe.
The goal is to pay exactly what’s justifiable, and not a dollar more.
- Too low → audit risk
- Too high → wasted payroll taxes
Once your salary is properly set, the remaining profits can be taken as distributions, which are not subject to FICA taxes. From there, you can layer on more advanced strategies, including:
- Accountable plans
- The Augusta Rule
- HSAs, Solo 401(k)s, SEP IRAs
- Additional tax-efficient structures
But everything starts with getting the salary right.
What This Means for S Corp Owners
An S Corporation can be a powerful tax planning tool when it is used correctly.
Paying yourself too much out of caution leads to unnecessary payroll taxes, while paying too little without support creates avoidable risk.
The right approach is finding a defensible balance.
At Taxfully, we help S Corp owners set the right salary using data and documentation that align with IRS standards. If you are unsure whether your current salary is optimized, a strategy call can help identify opportunities to improve.
