If you own an S-Corp and pay yourself, the IRS expects that payment to be "reasonable compensation" for the work you do. They don't tell you what reasonable means. They don't publish a chart. They just reserve the right to audit your number later and decide it was too low.
That's the part that catches owners off guard. Reasonable compensation isn't a formula. It's a benchmarking exercise — what would the business pay someone else to do the work you do? The IRS expects you to answer that question, document the answer, and stick to it.
Setting the number too low is the obvious mistake. The whole point of the S-Corp election is to save self-employment tax on profit distributions, so the temptation is to keep the W-2 salary as small as possible and call most of the take-home a distribution. The IRS knows this. They've won case after case where the salary was "unreasonably low" compared to the value of the work — and the consequences are brutal: back payroll taxes, penalties, interest, and reclassification of distributions as wages.
Setting the number too high is also expensive. Every dollar of W-2 wage is subject to 15.3% in self-employment tax (Social Security + Medicare), where every dollar of distribution isn't. Pay yourself $50,000 more than necessary and you've paid $7,650 in tax you didn't have to.
The right answer usually sits between 40% and 70% of net profit, but that range only matters if you can defend the number you picked. Three data sources do most of the heavy lifting.
The IRS doesn't publish a formula. They expect you to pick a defensible number — and document why.
One — salary benchmarking services. The cleanest evidence. Companies like RCReports and Salary.com publish benchmarks for specific job titles, regions, and industries. A consultant earning $250K in net profit can pull a report showing that a comparable senior consultant in their metro earns $135K base salary on average — and then pay themselves $135K, with the remaining $115K as a distribution. The benchmarking report itself is the documentation.
Two — industry compensation surveys. Trade associations publish annual compensation surveys for member firms. Construction contractors, medical practices, law firms, marketing agencies — almost every industry has one. The surveys are often more accurate than generic benchmarking because they reflect actual member-reported numbers. Saving a copy with your tax file is enough documentation in most audits.
Three — what you would actually pay someone else. Sometimes the cleanest defense is the simplest: "if I hired a CEO or operator to run this business instead of doing it myself, what would the market clear at?" If you've ever hired and paid someone in your industry, you already know the answer. Document your reasoning in writing — a short memo to file is enough — and the number becomes defensible because you put real thought into it.
What the IRS actually looks at in an audit. When the IRS examines reasonable compensation, they look at several factors in combination. Training and experience of the owner (higher skill, higher reasonable comp). Duties and responsibilities (are you doing CEO work, technician work, or both). Time and effort (full-time business or side venture). Dividend history (if you've been paying yourself huge distributions and minimal wages, that pattern itself raises a red flag). And what comparable businesses pay — the benchmarking question, viewed from outside.
The annual revisit. Reasonable compensation isn't a one-time decision. As the business grows, the comparable salary grows too. An owner of a $300K-profit business pulling $60K in wages and $240K in distributions is in a different position from the same owner four years later running a $1.2M-profit business and still pulling $60K. The second situation gets audited.
We revisit the number every year as part of tax planning — usually in November or December, after the year's revenue trajectory is clear. The mid-year adjustment is always cleaner than the after-the-fact correction. And the documentation is in place before anyone asks for it.