If you run your business as an S corporation, you get to split what you take out of the company into two buckets: wages that run through payroll, and distributions that do not. Wages carry Social Security and Medicare tax. Distributions do not. That difference is the whole reason many owners elect S corp status in the first place, and it is also why the IRS pays attention. Before you take a dollar of distributions, the law expects you to pay yourself a reasonable salary for the work you actually do.
The question every owner asks next is the obvious one: how much is reasonable? Here is the honest answer, and what to do about it before the year gets away from you.
There is no magic formula, and that is the point
Owners often hear a rule of thumb, something like a 60/40 split between salary and distributions. Those rules are not in the tax code. The IRS uses a facts and circumstances test, which means it looks at your specific situation and asks a simple question: what would you have to pay an unrelated person to do the job you are doing?
The factors that come up repeatedly in IRS guidance and Tax Court cases include:
- Your training, credentials, and experience
- The duties you actually perform and how much responsibility you carry
- The time and effort you put into the business
- What comparable businesses pay for comparable roles
- Your dividend and distribution history
- What you pay your non-owner employees
The anchor is the market rate for the work, not a fixed percentage of the bottom line. An owner who does sales, operations, and client delivery in a two-person shop is doing several jobs, and the salary should reflect that. Profit is not irrelevant, though. The IRS also looks at what actually generated your revenue, meaning how much came from your personal services versus from capital, equipment, or the work of other employees. A business whose income is driven mostly by the owner’s own labor supports a higher salary than one where the owner has built a team that does the work.
What happens when the number is too low
This is the risk most owners underestimate. If the IRS decides your salary was unreasonably low, it does not simply ask for the difference. It reclassifies distributions as wages, then assesses the back payroll taxes on both the employer and employee side, plus penalties and interest. Because interest compounds daily and the underpayment rate sits at 7 percent as of the third quarter of 2026, an adjustment reaching back a few years gets expensive quickly.
A pattern that draws attention: profits climb year after year while owner payroll stays flat. If your business has grown and your salary has not moved since you set it up, that gap is worth a look.
Too high is a real cost too
Overcorrecting is not free either. Every extra dollar of salary costs you Social Security tax up to the 2026 wage base of $184,500, plus Medicare tax with no cap at all. Salary also reduces the qualified business income that feeds the Section 199A deduction, because reasonable compensation paid to a shareholder employee is carved out of QBI.
That deduction matters more now than it used to. The One Big Beautiful Bill Act made the QBI deduction permanent rather than letting it expire. For 2026 the threshold amounts are $201,750 for single filers and $403,500 for joint filers. Below those thresholds the W-2 wage limits and the restrictions on specified service businesses generally do not apply, though the deduction is still capped by your qualified business income and your overall taxable income. Above them, the limits phase in. Setting salary well means finding the number that is genuinely defensible, not the highest or lowest one you can justify.
Why August is the right time to look at this
Payroll is a calendar-year exercise. If your salary is off, you still have four full months of payroll runs to correct it smoothly, spreading the adjustment across regular paychecks instead of scrambling to fix it with one awkward December bonus. Owners who wait until year-end often find the correction lands in a single period, spikes their withholding, and squeezes cash flow right when the holidays hit.
A mid-year review also gives you time to reconcile your salary with the rest of your plan, including retirement contributions and estimated payments, both of which depend on what your W-2 says.
Document the decision, not just the number
Documentation is what turns a reasonable position into a defensible one. Keep it simple and keep it in writing:
- Pull comparable wage data for your role, your industry, and your region. Bureau of Labor Statistics data and regional salary surveys work well for this.
- Write a short memo describing your duties and the share of your time each one takes.
- Record the salary decision in your corporate minutes.
- Revisit it annually, and note what changed when you adjust it.
If you are ever asked to explain the number, contemporaneous notes carry far more weight than a reconstruction built after the fact.
A note for Colorado and Hawaii owners
Your salary decision does not stop at the federal return. Wages drive state unemployment insurance, workers compensation classifications, and state withholding, and the rules are not the same in Colorado as they are in Hawaii. Whichever state you are in, check how a change to your salary flows through to those filings before you make it, since the state cost of a raise is easy to overlook when you are focused on the federal side.
Two situations deserve extra care. If you have an employee working remotely from another state, or you relocated and kept your old clients, confirm which state the wages should actually be reported to before you change anything.
The bottom line
A reasonable salary is not a number you set once and forget. It is a judgment call that should track the work you are doing and the size your business has grown to, backed by documentation you wrote at the time. Getting it right protects the tax advantage that made the S corp election worth making.
If you are not sure your salary would hold up, or you have not revisited it in a few years, reach out to Key2 Accounting. We help small business owners across Colorado and Hawaii set compensation they can defend and keep their payroll and tax planning working together.