How to Set a Defensible S-Corp Salary
In 2025, the rules surrounding S-corp “reasonable compensation” haven’t changed, but the IRS’s attention to this issue certainly has. More audits, better data matching, and a long history of court cases on the government’s side mean this topic remains one of the most important (and most Googled) parts of S-corp tax planning.
A defensible, common-sense method exists. And once you understand how the IRS thinks about owner salaries, the entire process becomes much less stressful.
Why Your Salary Matters More Than Ever
S corporations are popular because they allow profits to pass through to the owner without payroll tax as long as the owner first takes a reasonable salary for the work they actually perform.
The IRS requires owner-employees to be treated as employees first. If you’re doing real work, and almost all S-corp owners are part of your profit, it must be paid out as W-2 wages before you take distributions.
When salaries are too low, the IRS can reclassify your distributions as wages, assess payroll tax on them, and add penalties and interest. And because S-corps also attach Form 1125-E when receipts exceed $500,000, the IRS sees exactly who the officers are, how much they were paid, and how much time they devoted to the business. It’s never been easier for examiners to spot red flags.
How the IRS Actually Decides Whether a Salary Is Reasonable
While the term “reasonable” sounds vague, the IRS uses a surprisingly practical framework. If the company had to hire someone else with your background to perform the work you personally do, what would that cost?
Agents typically consider three angles:
- First, the market reality. They look at real-world compensation data for similar positions in similar industries. If you’re functioning as a CEO, lead salesperson, and operations manager all at once, they expect your pay to reflect the value of those responsibilities.
- Second, the replacement-cost approach. If the IRS believes the business would need to hire multiple people to replace the tasks you perform, such as a manager, a senior technician, and a bookkeeper, they may look at the combined market value of those roles.
- Third, the independent-investor test. This one is simple: after paying you your salary, does the company still generate a reasonable profit? If the business remains attractive to a hypothetical investor even after salary, the number is usually considered defensible.
What 2025 Means for S-Corp Owners
The attention around reasonable compensation isn’t limited to high-wealth taxpayers. Small and mid-sized S-corps are very much on the IRS radar, simply because underpaid owner salaries remain one of the largest compliance gaps in the entire tax system.
With better matching data and more automated notices, 2025 is a year where taking “just enough” salary without support is becoming riskier. Large profits with small W-2s, owners claiming minimal time devoted to the business, and massive year-end distributions after tiny salaries are exactly the patterns that prompt questions.
A Simple, Defensible Method for Setting Your Salary
One of the easiest and most defensible ways to determine your salary is to break down your role into the “hats” you actually wear. Most owner-operators don’t perform one job; they perform several.
Start by describing the real work you do each week. Not your title, but your tasks. Maybe you spend part of your time on strategy and leadership, part on sales or client work, and part on hands-on technical work. Write down an honest estimate of the hours per week you devote to each category.
Next, determine what each of those hats would cost on the open market. You can use national salary surveys, local job listings, industry compensation reports, or a blend of all three. If a full-time CEO in your industry earns $180,000 but you spend only a third of your time in that role, that slice may be worth around $60,000. If a senior technician earns $80,000 and you spend half your week doing technical work, that portion might represent $40,000. Add the slices together and you get a blended salary that naturally reflects the real work you perform.
This approach aligns closely with how IRS agents analyze replacement cost and comparable wages. It also creates a clear, rational paper trail, something missing in most S-corp audits.
Finally, run the independent-investor cross-check. After paying yourself the calculated salary, does the business still produce healthy profit margins? If so, your compensation is likely within a defendable range. If it doesn’t, your salary may be too high relative to the business’s performance.
Documenting Your Salary
The IRS doesn’t require a formal memo, but you should absolutely create one. Your documentation doesn’t need to be long. A one- to two-page summary works perfectly.
Include:
- A description of the roles you perform and your approximate weekly time in each.
- The market-rate data you used to price each role.
- A short explanation of how the salary was computed.
- A statement confirming that the business still produces a reasonable return after paying your wages.
What If You Haven’t Taken the Right Salary in the Past?
The IRS is far more interested in future compliance than in punishing honest mistakes. If your salary has been too low, adjusting it now is usually the best fix. Start paying yourself the amount justified by your memo, and align your quarterly payroll filings accordingly. Retroactive corrections are sometimes possible, but prospective compliance is cleaner and safer.
Also, remember that if your business has more than $500,000 in receipts, Form 1125-E will disclose your compensation and the time you devote to the company. Make sure the story your form tells matches the story your memo tells.
The Patterns That Get Noticed
Some scenarios consistently attract IRS attention:
- Large profits paired with very small or nonexistent wages
- Highly skilled owners reporting salaries at entry-level rates
- Big year-end distributions following a token paycheck
- Claims of minimal time spent in the business despite heavy involvement
None of these is an automatic violation, but each demands explanation. With documentation, they’re manageable. Without documentation, they’re red flags.
Want Certainty? Get Salary Check
Most S-corp owners want clarity on what’s safe, fair, and defensible. If you want confidence heading into 2025, we offer a quick meeting where we review your role, compare market data, run the independent-investor test, and provide a clean memo you can keep with your payroll and tax records.
And if your questions go beyond salary, whether it’s audits, IRS notices, payment issues, crypto reporting, or multi-year tax clean-up, we’re here for that too.
Schedule a consultation for any tax problem you’re facing, and we’ll help you get the right plan in place before it becomes a bigger issue.
