Tax
Reasonable Compensation
The market-rate wage an S-corp owner-employee must pay themselves before taking distributions — required by the IRS to prevent payroll-tax avoidance.
S-corp owners who actively work in the business must pay themselves a 'reasonable' W-2 salary before distributing remaining profit. Defensible reasonable compensation is based on BLS wage data, industry benchmarks, hours worked, and the complexity of duties performed.
The IRS aggressively audits low-salary / high-distribution S-corps. When it finds underpayment, it reclassifies distributions as wages and assesses back payroll tax + penalties + interest.
There's no bright-line rule for what's 'reasonable.' Documentation is the defense.
Common pitfalls
- Setting salary too low to maximize tax savings — invites audit
- Setting salary based on what's been 'good enough so far' instead of running a fresh analysis annually
- Forgetting that fringe benefits (health insurance, HSA, retirement) for >2% shareholders have special S-corp rules
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