What is Reasonable Compensation for S Corporation Officers?

S Corporation officers who perform services for their company are required to pay themselves a reasonable salary before taking any distributions from the business. The IRS enforces this rule because wages are subject to payroll taxes while distributions are not, which creates a temptation to pay a token salary and take most of the money out as distributions to reduce the overall payroll tax burden. Reasonable compensation is generally what a similar business would pay an unrelated person to perform the same services, and it should be based on factors like industry pay data, the complexity of the work, and the hours involved. If the IRS audits an S Corporation and determines that officer compensation is unreasonably low, it can reclassify distributions as wages and assess back payroll taxes, interest, and penalties. The best protection is to document how you calculated your salary, keep records of your duties and hours, and review your compensation annually as the business grows.