Why Your S Corp Salary Might Be Too High — And What It’s Costing You in Taxes
Electing S Corporation status is one of the most effective ways small business owners can reduce self-employment taxes. But even among S Corp owners who’ve made the right move, many end up paying more than they need to — not because they underpay themselves, but because they overpay.
Out of fear of the IRS, many business owners set their own salary too high — and in doing so, end up losing thousands of dollars a year in unnecessary payroll taxes. What feels like “playing it safe” can quietly erode cash flow and increase exposure to audit scrutiny if it’s not supported by data.
Let’s break down why this happens, what the IRS actually requires, and how to confidently set a tax-efficient salary that’s both compliant and strategic.
What Does the IRS Require for S Corp Salaries?
If you’re an owner-employee of an S Corporation and perform services for your business, the IRS requires you to take a reasonable salary before taking any shareholder distributions.
This salary must be reported on a W-2, and both the business and the employee pay payroll taxes (Social Security and Medicare) on the wages.
But here’s the nuance:
The IRS doesn’t define a specific dollar amount or percentage. Instead, they look at facts and circumstances — and expect that salary to reflect the value of the services provided.
If you take too little, the IRS could reclassify distributions as wages, triggering back taxes and penalties.
If you take too much, you’re simply overpaying payroll taxes without any compliance benefit.
How Overpaying Hurts You Financially — And What to Consider First
Let’s say your business brings in $250,000 in net income for the year. To play it safe, you set your S Corp salary at $160,000 and take the remaining $90,000 as distributions. The result?
You’re paying full payroll tax on a salary that may be unnecessarily high — which could mean $8,000–$12,000 in avoidable tax each year. Not to mention reduced cash flow for reinvestment or retirement planning.
Now imagine instead you paid yourself $65,000 and took the remaining $185,000 as distributions (assuming a valid RCReport or reasonable comp justification).
That adjustment alone could free up thousands without exposing you to audit risk — if it’s supportable.
But here’s where it gets more nuanced:
What if there were no distributions at all? Does a salary still apply?
Some business owners wonder:
“If I didn’t take distributions this year — just left the earnings in the business — do I still need to take a salary?”
The short answer: Yes — most of the time.
The IRS focuses on whether the shareholder provided services, not whether they received a distribution.
So even if all profits are retained in the business or booked as Additional Paid-In Capital (APIC), if you’re materially involved in operations, reasonable compensation is still required. The IRS doesn’t wait for distributions to trigger their wage requirement.
There are narrow exceptions (like a truly inactive shareholder), but if you’re working in the business — you’re expected to pay yourself.
What about the “30% rule”? Is that real?
There’s a common belief that your salary should be “at least 30%” of your income — but the IRS does not publish any fixed percentage.
That number likely originated from tax court cases or informal CPA practice standards — but it’s not an official threshold.
Instead, the IRS requires facts and circumstances analysis. In practice, percentages are useful benchmarks, but they aren’t audit-proof on their own.
So whether you’re paying yourself 30%, 50%, or 70% of profits — what matters is whether you can justify that amount based on your role, hours, duties, and market standards.
What Counts as “Reasonable Compensation”?
The IRS considers several factors:
- Your duties and responsibilities
- Time devoted to the business
- What similar businesses pay for similar services
- Your training and experience
- The business’s gross and net income
- Compensation agreements, if any
- Use of company assets or property
These aren’t theoretical — they are directly listed in IRS guidance and have been cited in tax court rulings.
How to Support Your Salary: What the IRS Expects
The IRS doesn’t define a specific salary number — instead, it looks at a range of facts and circumstances to determine if your compensation is reasonable for the services you provide.
A supportable salary generally considers:
- Your industry and geographic location
- The size and profitability of your business
- Your qualifications, time commitment, and role breakdown
(strategic work vs. technical tasks vs. admin support) - What other businesses would pay for similar work
Documenting these factors is critical. Whether you use third-party data, salary surveys, or a professional compensation analysis, the goal is the same:
To justify your number with credible support in case the IRS ever asks.
At Taxfully, we help ensure your salary is defensible — not just estimated. That way, you’re not overpaying taxes out of caution, but you’re never exposed either.
The Sweet Spot: Strategic Salary + Tax Savings
The goal isn’t to pay yourself the lowest possible number. It’s to pay yourself what’s justifiable, and not a dollar more.
- Too low = audit risk.
- Too high = wasted payroll tax.
The right salary balances what you do, what’s defensible, and what keeps your business tax-efficient.
Once your salary is locked in, you can take the remainder of profits as distributions — not subject to FICA taxes. You can also begin layering on advanced strategies like:
- Accountable plans (reimburse tax-free for home office, phone, internet, etc.)
- Augusta Rule (rent your home to your business, tax-free up to 14 days/year)
- Fringe benefits (e.g., HSA, ICHRA, SEP IRA, Solo 401(k))
- Management companies to split services and stack retirement contributions
But it all starts with setting the right salary.
Final Thoughts
As an S Corp owner, you have one of the most powerful tax planning tools available — but it only works if you use it wisely.
If you’re setting your salary too high out of fear, you’re not safer — you’re just paying more than you need to.
And if you’re setting it too low without support, you’re inviting unnecessary audit risk.
