Reasonable compensation is the W-2 salary an S corporation must pay a shareholder who works in the business before taking profit distributions. Because distributions escape self-employment and payroll taxes while wages do not, the IRS polices owners who pay themselves little or no salary and take everything as distributions. When it wins, the IRS recharacterizes distributions as wages and assesses back payroll taxes, penalties, and interest. There is no statutory formula: reasonableness is measured by what comparable businesses pay for similar services, considering training, duties, time committed, and the scale of the company. In practice, owners document a defensible number using market salary data for their role and hours, revisit it as profits grow, and keep the analysis on file. The same concept caps excessive salaries in C corporations from the opposite direction.
Reasonable Compensation
Primary authority: Rev. Rul. 74-44; IRC §3121(d)(1)
The authority behind it
Rev. Rul. 74-44; IRC §3121(d)(1)
Every entry in this glossary cites the statute, regulation, or IRS guidance behind it.
Worked example
An S corporation nets $300,000. Market data shows a full-time manager in the owner's role earns about $120,000, so the owner runs $120,000 through payroll and takes $180,000 as distributions, saving Medicare and Social Security tax on the distribution portion while staying defensible.
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Related terms
S Corporation
An S corporation is a corporation or an LLC that elects corporate treatment that has filed a valid election under...
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Shareholder Distributions (S Corporation)
A shareholder distribution is cash or property an S corporation pays to its owners outside of payroll.
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Self-Employment Tax
Self-employment tax is Social Security and Medicare for people who work for themselves: sole proprietors,...
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