By Gruv Editorial Team
So, you did the smart thing. You formed an S-Corp to optimize your taxes and take home more of your hard-earned money. It felt like a major win. But now a single, nagging question has started to creep in, probably late at night: "Am I paying myself enough?"
You’re staring at your profits, and instead of feeling proud, you feel a knot of anxiety. You worry that one wrong move in calculating your reasonable salary could undo all your hard work. That it could trigger the one thing every freelancer dreads: a letter from the IRS.
Let’s put that fear to rest, right now.
This guide is here to demystify the whole concept of "reasonable salary." We're going to translate the vague government guidelines into a clear, practical framework you can actually use. You'll learn not just the rules, but the reasoning behind them. This is about empowering you to confidently set your salary, maximize your tax savings, and finally get a good night's sleep knowing you’re doing things the right way.
Imagine your S-Corp's profit is a freshly baked pie sitting on the counter. The IRS is standing right there, and they've handed you a knife. They say you have to cut that pie into two different kinds of slices: one is your "salary," and the rest is your "distribution."
Why are they so invested in how you slice it? Simple. Because they tax each slice differently.
This distinction is the entire reason you likely formed an S-Corp in the first place. It's the core of the tax advantage, and it’s also the IRS's number one focus.
Let's break it down. The slice you label salary is treated as wages. It's the money you pay yourself for doing the actual work—the writing, the designing, the consulting. And just like any employee's paycheck, it’s subject to payroll taxes. We're talking about Social Security and Medicare. Those are the taxes that fund our social safety nets.
Now, the other slice—the distribution—is your share of the company’s profit. This is the beautiful part. This money is not subject to those same payroll taxes. This is the primary tax benefit we're all chasing. It's how you can save thousands of dollars a year.
See the temptation? You might think, "Great! I'll just pay myself a tiny salary of, say, $5,000, and take the other $95,000 as a distribution. I'll save a fortune!"
And that's precisely why the "reasonable salary" rule exists.
The IRS isn't naive. They created this rule to prevent S-Corp owners from gaming the system by paying themselves a ridiculously low salary to dodge their payroll tax obligations. It’s the government's way of making sure you’re paying your fair share into the systems everyone relies on. Paying yourself nothing while taking home big profits isn't smart tax planning; it's a huge red flag that screams "audit me."
Alright, let's talk about the number. The IRS doesn't hand you a calculator with a big red "REASONABLE" button. It's frustrating, I know. You hear all this talk about a multi-factor test and vague guidelines, and it's enough to make you want to just pull a number out of thin air and hope for the best.
Don't do that.
Here’s the secret: for a moment, stop thinking like the overwhelmed business owner and start thinking like a hiring manager.
Imagine your business posts a job opening for your exact role. What would you offer a qualified candidate to do everything you do? The strategy calls, the client management, the late-night coding, the marketing, the bookkeeping—all of it. That figure, the one you'd use to attract real talent, is the foundation of your reasonable salary.
The IRS essentially wants you to prove you did this homework. They want to see that your salary isn't based on a hunch, but on market data. This is your most important job as the "hiring manager" of your own company. You need to build a case file.
Your mission is to find what similar businesses pay for comparable work. This isn't a five-minute task, but it's the work that lets you sleep at night.
Put all of this—the screenshots, the salary range reports, your official job description—into a folder. This file is your shield. If the IRS ever comes knocking and asks why you paid yourself $85,000, you don't have to sweat. You can simply open the folder and show them exactly how you arrived at that defensible, evidence-based number.
Alright, let's get into the nitty-gritty. This is where the theory meets the road, and it’s where most of the anxiety around S-Corps lives. We're going to tackle those "what if" questions that are probably swirling in your head right now with some clear, direct answers.
Alright, let’s land this plane. You've just absorbed a ton of information, and it’s easy to feel a little overwhelmed. The real danger now isn't the IRS; it's inertia. It's letting this article become just another tab you've bookmarked for "later."
Don't do that. Let’s turn this knowledge into actual peace of mind, right now.
Think of this less as a one-and-done chore and more like building a fire escape for your business. You put in the work upfront to build a clear, safe path so that if there's ever a fire drill, you know exactly what to do. You don't have to panic. You just follow the process. Here’s how you build your framework for confident compliance.
The short answer? Generally, no. The entire point of the reasonable salary requirement is tied to the distribution of profits. If your business has zero net income for the year and you aren't taking any money out of the company (as a distribution), then there are no profits to worry about. The IRS doesn't expect you to pay yourself a salary from a business that isn't making any money. Just remember, the moment you start taking distributions, you need to have that salary in place first.
Absolutely. In fact, it should. Think about it: does your role stay exactly the same every single year? Of course not. Your business grows. You take on more management duties. Or maybe you have a lean year and have to cut back. Your salary should reflect that reality. Make it a non-negotiable annual review. Sit down, look at your company’s performance, any changes in your responsibilities, and the latest market data. Adjust accordingly. This isn't a "set it and forget it" number.
I hear this one all the time, and I need to be really clear: No. This is probably the most dangerous piece of S-Corp folklore out there. While it might sound like a simple solution, the "60/40 Rule" is not an official IRS guideline, and it offers you zero protection in an audit. Relying on an arbitrary ratio is like telling a judge you "felt" you were driving at a reasonable speed. The IRS wants to see your work. They want to see that you researched your market value, not that you applied a generic, unsubstantiated percentage. It’s a shortcut that can lead you right off a cliff.
Think of it this way: you're building the case file that proves you did everything right, long before anyone ever asks to see it. This isn't about creating a mountain of paperwork; it's about having a slim, powerful compliance file. Here’s what should be in it:
This is the scenario that keeps people up at night, so let's be direct. If the IRS audits you and determines your salary was unreasonably low, they have the power to reclassify your distributions as wages. This means all that money you took as a tax-advantaged distribution is suddenly treated as salary. And what comes with salary? Payroll taxes. You will be on the hook for all the unpaid Social Security and Medicare taxes—both the employee and employer portions—on that reclassified amount. On top of that, you can expect to pay steep penalties and interest. It’s a financial headache you can easily avoid by doing the work upfront.