Are you paying yourself too much or too little from your S-Corporation? The IRS has strong opinions about this, and they matter for your tax bill. Let’s break down what “reasonable compensation” really means for S-Corp owners and how to stay on the right side of the rules.
Why Reasonable Compensation Matters for Your S-Corporation
I’ve seen countless S-Corp owners get this wrong. You work hard building your company, wear multiple hats daily, and when it comes time to pay yourself, you might think “It’s my business—I’ll decide what I’m worth!”
But here’s the reality: the IRS is watching closely, especially when it comes to S-Corporations.
Why? Because S-Corps offer a unique tax advantage: only your salary (not distributions) is subject to self-employment taxes. This creates a powerful incentive to minimize your salary and maximize distributions—something the IRS is well aware of.
The difference between “reasonable” and “unreasonable” compensation isn’t just semantics—it’s dollars and cents on your tax return. Reasonable compensation is fully deductible under tax code section 162(a)(1), while if your compensation is deemed too low, the IRS can reclassify distributions as wages subject to employment taxes.
The stakes are high for S-Corp owners. Set your salary too low, and you’re looking at back taxes, penalties, and the headache of an audit. Set it too high, and you might be overpaying self-employment taxes. Get it right, and you’ve optimized your tax situation while maintaining a defensible position with the IRS.
Where Did This Test Come From? (And Why Should You Care?)
You might be wondering, “Who decided what’s ‘reasonable’ anyway?” Great question.
The 9-factor test wasn’t invented by IRS bureaucrats in a conference room. It evolved from real court battles, most notably the 1949 case Mayson Manufacturing Co. v. Commissioner. When Mayson’s compensation deductions were challenged, the Sixth Circuit Court created this framework that’s now the gold standard for evaluating pay reasonableness.
Later cases like Owensby & Kritikos, Inc. v. Commissioner (1987) refined the approach, and the IRS has since incorporated these factors into their guidance, including Technical Advice Memorandum 9326001.
Why does this history matter to you? Because understanding the origins helps you see that these aren’t arbitrary rules—they’re battle-tested guidelines that have withstood decades of tax court scrutiny.
Breaking Down the 9 Factors: Your Compensation Defense Blueprint
Let’s get practical. Here’s how the IRS and tax courts will evaluate whether your compensation passes the “reasonable” test:
Factor #1: Your Qualifications (Yes, They Matter)
Think of this as your professional resume in the eyes of the IRS:
- What education, training, and certifications do you bring to the table?
- How many years have you worked in this industry?
- What specialized skills make you valuable to your own company?
- Would another company pay for your expertise? How much?
Real-world application: A medical practice owner with 20 years of experience, board certifications, and specialized surgical skills can justify significantly higher compensation than a new practitioner with basic qualifications.
Pro tip: Keep your professional credentials updated and documented. That MBA you earned nights and weekends? That specialized industry certification? They help justify your compensation level.
Factor #2: What You Actually Do (Your Value Goes Beyond Your Title)
This factor examines your day-to-day contributions:
- Are you working 70-hour weeks while wearing multiple hats?
- Are you directly responsible for landing major clients or developing key products?
- Do you handle responsibilities that would require several employees in a larger company?
- How critical is your role to the company’s success?
Real-world application: The owner of a construction company who estimates jobs, manages projects, handles client relationships, AND performs skilled labor can justify higher compensation than someone who only performs administrative functions.
Pro tip: Track your time across different roles. If you’re functioning as CEO, CFO, and head of sales all at once, document it. This “multiple-hat premium” can justify higher compensation than industry standards for a single role.
Factor #3: Your Business Size and Complexity (Context Matters)
Not all businesses are created equal:
- Running a $20 million manufacturing operation is different from managing a $200,000 consulting practice
- Multiple locations create different challenges than a single office
- Complex regulatory environments justify higher compensation
- Industry-specific challenges factor into reasonable pay levels
Real-world application: The CEO of a 75-employee manufacturing company with international supply chains, stringent regulatory requirements, and complex production processes can reasonably earn more than the owner of a local retail store with five employees.
Pro tip: When benchmarking your compensation, make sure you’re comparing apples to apples. Your business’s unique challenges matter when justifying your pay.
Factor #4: Money In, Money Out (The Financial Reality Check)
This factor is where math meets reasonableness:
- What percentage of your company’s revenue goes to your compensation?
- What percentage of profits (before your pay) are you taking?
- How do these percentages compare to industry averages?
- Are you taking almost everything out as salary, leaving little behind?
Real-world application: If your S-Corporation generates $500,000 in profit, and you pay yourself only $40,000 in salary while taking $460,000 in distributions, the IRS will likely argue that your salary is unreasonably low. Conversely, if you’re paying yourself a $250,000 salary when comparable positions in your industry earn $150,000, you might be overpaying employment taxes.
Pro tip: Track compensation ratios year over year. For S-Corps, most tax professionals recommend wages should be at least 25-40% of profits, though the right percentage varies by industry, company size, and owner involvement. Consistent patterns help demonstrate that your compensation philosophy is sound rather than opportunistic tax planning.
Factor #5: Economic Conditions (Sometimes, It’s Not Just About You)
The world around your business influences what’s reasonable:
- Is your industry booming or struggling?
- What’s happening in your local economy?
- Are specialized skills like yours in high demand or oversupply?
- How has inflation affected comparable compensation?
Real-world application: During the 2020 pandemic, many business owners temporarily reduced their compensation. Those who maintained or increased their pay despite industry downturns faced greater scrutiny. Conversely, rapid compensation increases during boom times in your industry are easier to justify.
Pro tip: Document economic factors affecting your compensation decisions. If you’re increasing pay during tough times, have solid business reasons ready to explain why.
Factor #6: Compensation vs. Distributions (The S-Corp Danger Zone)
This is often where S-Corp owners trip up:
- What’s the ratio between your W-2 wages and distributions?
- Is your salary unreasonably low compared to the distributions you’re taking?
- How does your total compensation compare to what you’d pay someone to do your job?
- Are you taking minimal salary to avoid payroll taxes?
Real-world application: If your S-corporation makes $300,000 in profit, you pay yourself $30,000 in salary and take $270,000 in distributions, the IRS will likely view this as attempting to avoid self-employment taxes. Many tax courts have ruled that S-Corp owner-operators must pay themselves reasonable market-rate compensation before taking distributions.
Pro tip: Consider a formula-based approach to both compensation and distributions. For example, setting your salary at 70% of what you’d pay someone to replace you, with documented market data to support this figure, creates a defensible position. Then establish a consistent policy for when and how distributions are taken.
Factor #7: Market Rates (What Would Someone Else Pay You?)
This is the “reality check” factor:
- What do similar businesses pay for comparable positions?
- What would it cost to hire someone with your qualifications?
- How does your total compensation package (not just salary) compare to market?
- Are there regional differences that affect comparable salaries?
Real-world application: If you’re paying yourself $300,000 as CEO of your small accounting firm, but compensation studies show similar-sized firms typically pay $180,000-$220,000, you’ll need strong justification for the premium.
Pro tip: Invest in quality compensation surveys specific to your industry, company size, and region. These third-party validations are worth their weight in gold during an IRS examination.
Factor #8: Your Company’s Overall Salary Policy (Playing Favorites?)
The IRS looks at your compensation in context:
- Are you paying yourself lavishly while keeping staff underpaid?
- Do bonus structures exist only for owners or for all employees?
- Is there a consistent compensation philosophy that applies to everyone?
- How wide is the gap between your pay and your highest-paid non-owner employee?
Real-world application: A company where the owner makes $1 million while similar-skilled managers make $80,000 raises questions. Conversely, a company with generous compensation at all levels can more easily justify higher owner pay.
Pro tip: Develop a formal compensation philosophy document that outlines how pay decisions are made across the organization. This demonstrates that owner compensation isn’t arbitrary but follows the same principles applied to all employees.
Factor #9: Compensation History (The Long View Matters)
Your compensation story over time can help or hurt your case:
- Have you been consistently paid at similar levels?
- If there’s a sudden increase, is there a business reason for it?
- Were you underpaid in early years when building the business?
- Does your compensation fluctuate with company performance?
Real-world application: If you took minimal salary during your company’s first five years while building the business, a “catch-up” period of higher compensation may be reasonable. Conversely, dramatically increasing your pay the year before selling your business looks suspicious.
Pro tip: If you’ve been underpaid in previous years, document this contemporaneously. Board minutes acknowledging “below-market compensation due to cash flow constraints” create a paper trail that supports future increases.
Putting It All Together: How to Bulletproof Your Compensation
The most important thing to understand is that no single factor determines reasonableness. The IRS and courts look at the complete picture. Here’s how to strengthen your position:
1. Document, Document, Document
The time to prepare your defense is before you ever hear from the IRS. For every compensation decision:
- Create contemporaneous written records explaining the rationale
- Have your board or management team formally approve compensation
- Record minutes of compensation discussions
- Retain industry compensation studies that support your decisions
Why it works: Documentation created at the time of the decision carries far more weight than explanations developed during an audit. The IRS knows the difference.
2. Be Consistent (But Explain Changes)
Dramatic swings in compensation raise red flags:
- If you’re increasing pay substantially, document specific business reasons
- If company profits rise and fall but your compensation always rises, be prepared to explain why
- Align compensation changes with measurable business metrics when possible
Why it works: Consistency suggests your compensation is based on services rendered rather than tax planning. When changes are necessary, contemporaneous documentation of business reasons helps justify them.
3. Get Professional Validation
Third-party validation significantly strengthens your position:
- Commission professional compensation studies for key positions
- Have your compensation package reviewed by independent board members or advisors
- Document market comparisons from credible sources
- Consider having specialized tax professionals review your approach
Why it works: External validation demonstrates that your compensation decisions weren’t made in a vacuum but reflect reasonable market practices.
4. Balance Your Total Compensation Package
How you pay yourself matters almost as much as how much:
- Consider appropriate mixes of salary, bonuses, retirement benefits, and dividends
- Align bonus structures with specific performance metrics
- Implement similar (if scaled) structures for non-owner employees
- Document the business purpose behind each component
Why it works: A thoughtfully structured compensation package demonstrates that you’re treating components appropriately rather than trying to disguise distributions as compensation.
What’s Happening in 2025: Current S-Corp Trends You Should Know
The reasonable compensation landscape for S-Corps continues to evolve. Here’s what I’m seeing in 2025:
- S-Corps are under the microscope. With expanded funding, the IRS has specifically targeted S-Corporation compensation practices in its compliance campaigns, focusing on businesses where the salary-to-distribution ratio appears suspiciously low.
- Technology is changing the game. The IRS is using more sophisticated data analytics to identify S-Corp owners whose compensation falls significantly below industry norms or whose ratio of salary to distributions is unusually low.
- Courts are setting clearer standards. Recent tax court decisions have established more specific guidelines for S-Corp reasonable compensation, with some courts suggesting that owner-operators should generally receive salaries equal to at least 70% of comparable market rates.
- The “zero salary” strategy is dead. In multiple recent cases, courts have rejected arrangements where S-Corp owners took only distributions and no salary, imposing penalties in addition to reclassifying distributions as wages.
- Safe harbors are emerging. While not official IRS policy, tax practitioners are seeing patterns where S-Corps with owner salaries at 30-35% of net profits generally face less scrutiny, though this varies significantly by industry.
The Bottom Line: Finding the S-Corp Sweet Spot
Here’s what many S-Corp owners get wrong: reasonable compensation isn’t about paying yourself as little as possible to minimize payroll taxes. The courts have repeatedly rejected this approach, costing business owners far more in back taxes, penalties, and interest than they saved.
But it’s also not about overpaying yourself. The S-Corporation structure offers legitimate tax advantages when used correctly.
The key is finding the defensible middle ground—a salary that truly reflects the market value of your services while acknowledging that part of your company’s profits represent return on investment rather than compensation.
Get this right, and you’ll sleep better during tax season knowing you’ve built a defensible position based on solid business reasoning and the nine factors courts actually use to evaluate reasonableness.