Operating your business as an S-corporation comes with a significant tax advantage. Distributions to shareholders are not subject to self-employment tax. But the IRS has a rule designed to prevent business owners from taking advantage of it without limits. It is called the reasonable salary requirement. And it is one of the most frequently violated rules in small business tax.
What the Rule Actually Requires
If you are an owner-employee of your S-corp, the IRS requires that you pay yourself a reasonable salary before taking any distributions. That salary is subject to payroll taxes. The IRS defines reasonable based on what you would pay someone else to do your job. If you are a consultant billing $200 per hour, paying yourself $20,000 in salary while taking $180,000 in distributions will raise flags.
How the IRS Identifies Violators
The IRS runs automated screening that compares the ratio of W-2 wages to total S-corp distributions. When that ratio falls outside reasonable ranges for your industry and revenue level, it becomes a trigger for examination. An audit costs you the back taxes, plus penalties, interest, and the payroll taxes that should have been paid all along.
The Right Way to Structure S-Corp Compensation
Your reasonable salary should be documented in writing, based on comparable market wages, run through actual payroll, and reviewed annually as your revenue changes. At 360 Global Business LLC, we help S-corp owners establish compliant payroll structures that protect them from audit exposure while legally minimizing overall tax liability.
Have you paid yourself a defensible salary this year? Book a Business Tax Consultation: 360globalbusinessllc.com/tax-services
Shannon C. Williams | CEO, 360 Global Business LLC | 27 Years Federal Tax Educator and Consultant | SDVOSB · WOSB · MBE | U.S. Air Force Veteran | 1-855-500-1514 | (360) 300-4487 | taxes@360globalbusiness.com