Why the salary matters so much
The whole tax case for an S corporation rests on the split between wages and distributions. Wages carry FICA; distributions do not. That makes the salary the figure the IRS looks at most closely, and it has said so plainly.
In fact sheet FS-2008-25, the IRS explains that corporate officers are employees for FICA, federal unemployment and income tax withholding, and that S corporations should treat payments for services to officers as wages and not as distributions. Its S corporation compensation page adds that an S corporation must pay reasonable compensation to a shareholder-employee for services before non-wage distributions may be made, and that the IRS has the authority to reclassify distributions as wages.
The IRS also notes that the amount of reasonable compensation will never exceed the amount received by the shareholder, directly or indirectly. An owner who takes nothing out in a lean year does not create wages that were never paid; the issue arises when money comes out labeled as distributions.
The factors the IRS lists
The IRS says there are no specific guidelines for reasonable compensation in the Code or the regulations. It lists factors that courts have used to decide the question:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
The source-of-receipts approach
The IRS describes the key to establishing reasonable compensation as working out what the shareholder-employee did for the business, by looking at where its gross receipts come from. It names three sources: the shareholder's own services, services of non-shareholder employees, and capital and equipment.
To the extent receipts come from employees' work and from capital and equipment, payments to the shareholder can properly be non-wage distributions. To the extent they come from the shareholder's personal services, the payments should be treated as wages.
For a one-person consulting practice, almost all receipts come from the owner's services, which points toward a salary close to the value of that work. For a business with a crew, vans and equipment, a larger share of receipts comes from other sources, and a salary well below profit can be easier to support.
The court cases the IRS cites
The IRS's own compensation page lists these cases as background to its position. They are worth knowing by name because they are the ones most often discussed.
| Case | What the IRS cites it for |
|---|---|
| Joly v. Commissioner, T.C. Memo. 1998-361, aff'd 211 F.3d 1269 (6th Cir. 2000) | The IRS's authority to reclassify payments to shareholders as wages |
| Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141 (2001) | Shareholders who perform services are employees |
| Joseph M. Grey Public Accountant, P.C. v. Commissioner, 119 T.C. 121 (2002) | Shareholders who perform services are employees |
| David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012) | Reasonable pay for services performed |
There is no 60/40 rule
You will see a "60/40 rule" described online, usually as paying yourself 40% of profit as salary and taking 60% as distributions, and some tools fill in a percentage for you. That split does not appear in FS-2008-25 or on the IRS's S corporation compensation page. The IRS's position is the opposite of a formula: no specific guidelines, a list of factors, and a focus on the value of the services.
A percentage can be a coincidence. If a salary that reflects your duties and market pay happens to equal 40% of profit, that is fine. What does not work is starting from the percentage and calling the result reasonable.
How to set a figure you can explain
A practical approach works from the job, not from the profit:
- 1.List what you actually do in the business and roughly how your time splits between the work itself, management, sales and administration.
- 2.For each role, find what it would cost to hire someone to do it: job postings, published wage data for your area and occupation, and what you pay any employees doing similar work.
- 3.Weight those figures by the time you spend in each role, and consider your training and experience.
- 4.Look at where receipts come from: your own work, staff, or equipment and capital.
- 5.Check the figure against the cash the business can actually pay, and against distributions you expect to take.
- 6.Write down the result, the sources and the reasoning, and revisit it each year or when your role changes.
Documenting the choice
If the salary is ever questioned, the useful evidence is whatever shows how it was set and when. A short memo in the company's records, dated when the salary was decided, is far more persuasive than a reconstruction years later.
The memo does not need to be elaborate. It should say what you do, how many hours, what comparable pay you found and where, and why you settled where you did. Keep the supporting job postings or wage data with it. If you run minutes or written consents for the corporation, record the salary decision there too.
- A description of your duties and approximate hours
- Comparable pay data with sources and dates
- How receipts split between your services, staff and equipment
- The salary decided, the date and who decided it
- A note of anything that changed since last year
Where we come in
We can help you work through the factors, assemble comparable pay information and put the reasoning in writing, and then show what that salary does to the overall comparison. We can run the comparison with your actual numbers so the salary and the tax result are looked at together. Payroll itself is coordinated with your payroll provider; what we do there is payroll support. We give you a scope and a price in writing before anything starts.
Figures on this page were checked against the IRS and Massachusetts sources listed alongside on 28 Sep 2026. They change — confirm the current amount before relying on one.
General information for owner-led businesses, not advice for your specific situation. Tax and accounting rules change, and how they apply depends on facts particular to your business. Talk to us — or to another qualified professional — before acting on anything here.
