Why the IRS cares
An S Corporation’s profit is taxed on the owner’s personal return whether it comes out as salary or as distributions. The difference is payroll tax. Salary carries Social Security and Medicare tax, and distributions do not. That is why the IRS says an officer who works in the business must be paid a reasonable salary, and that S Corporations should not avoid employment taxes by calling pay a distribution, a personal expense payment or a loan.
What makes a salary reasonable
There is no formula in the tax code. The IRS lists the factors courts look at, including:
- Your training and experience.
- Your duties and responsibilities, and the time and effort you put into the business.
- What comparable businesses pay for similar services.
- What the business pays employees who are not owners, and how it pays bonuses to key people.
- The company’s distribution history and any compensation agreements.
The practical question is simple: what would the business have to pay a non-owner with your skills to do what you do, for the hours you work?
Three ways to support the number
- Market approach. Compare your pay with salary surveys for the same role, industry and region. The IRS’s own valuation guide says courts favor it.
- Cost approach, or many hats. Split your work into roles, such as consultant, office manager and bookkeeper, and price each one for the share of time you spend on it. Adding up several full-time salaries overstates it.
- Income approach. Asks whether an outside investor would still earn a fair return after your salary. It needs a value for the whole company, so it is used less often.
Write down how you got the number and keep the data. That file is your support if the IRS ever asks.
A worked example
William owns a consulting firm taxed as an S Corporation. It earns $200,000 before his salary and the S Corporation’s share of payroll taxes. He is married, files jointly, takes the $32,200 standard deduction and has no other income. Here is his 2026 federal tax as a sole proprietor on Schedule C, and as an S Corporation paying him $80,000 or $120,000.
| Sole proprietor: self-employment tax | $28,234.30 |
| Sole proprietor: income tax | $16,472.18 |
| Sole proprietor, total | $44,706.48 |
| $80,000 salary: Social Security and Medicare, both halves | $12,240.00 |
| $80,000 salary: income tax | $19,982.88 |
| $80,000 salary, total | $32,222.88 |
| $120,000 salary: Social Security and Medicare, both halves | $18,360.00 |
| $120,000 salary: income tax | $21,204.32 |
| $120,000 salary, total | $39,564.32 |
| Saved with an $80,000 salary | $12,483.60 |
| Saved with a $120,000 salary | $5,142.16 |
At $80,000, payroll taxes drop by $15,994.30, but income tax goes up by $3,510.70. Two things cause it. Salary is not qualified business income, so his 20% QBI deduction falls from $30,736.57 to $22,776. And a sole proprietor deducts half of his self-employment tax, $14,117.15, while the S Corporation deducts only its $6,120 half of the payroll tax. Between the two salaries, every extra $10,000 of salary costs William about $1,835 in federal tax.
These are federal numbers before the cost of running payroll: the payroll provider’s fee, New Jersey unemployment and disability contributions on the salary, and New Jersey’s minimum tax on S Corporations, $375 to $1,500 a year depending on receipts. At $120,000, the savings get thin.
The table does not pick the salary. If consultants with William’s experience earn $120,000 for the hours he works, $80,000 is the number the IRS would question.
The QBI deduction at higher incomes
For 2026, owners with taxable income under $403,500 on a joint return, or $201,750 for other filers, generally get the full 20% deduction. Above that, the deduction is limited by the W-2 wages the business pays, so for many businesses a higher salary can raise it. Consulting, law, accounting and health are specified service businesses: their deduction phases out and is gone at $553,500 on a joint return, or $276,750 for other filers. The July 2025 federal law made the deduction permanent.
Health insurance for owners
If the S Corporation pays health insurance for an owner of more than 2%, the premiums go in box 1 of the owner’s W-2 but are not subject to Social Security, Medicare or federal unemployment tax. The owner then generally deducts them as self-employed health insurance on Form 1040. Tell your payroll provider before the last payroll of the year.
What a zero or token salary risks
- Reclassification. The IRS can treat distributions as wages. In a 2012 federal appeals court case, a CPA paid himself $24,000 a year, and the court accepted $91,044 as reasonable.
- Back payroll taxes on the reclassified amount, plus penalties and interest.
- Payroll returns to fix for every year involved, federal and New Jersey.
How we help
We do not run payroll. Your payroll provider does. As a client, we can refer you to a payroll provider with preferred pricing. We help you set the salary, document how we got it, and check it each year against your profit, along with whether the NJ BAIT election makes sense. For a quick estimate, try our S Corporation calculator.
This guide is general information based on the law as of the date above, not advice for your situation. Tax rules change, and the right answer depends on your numbers.