How much salary should an S corp owner pay themselves?

An S corporation must pay reasonable compensation to a shareholder who works in the business before it makes non-wage distributions to that shareholder. The Form 1120-S instructions say distributions and other payments to a corporate officer must be treated as wages to the extent they are reasonable compensation for services.

The IRS has also said the tax code and regulations give no specific guidelines for the amount. Courts decide case by case. That is why there is no safe percentage.

The "60/40 rule" is a myth. You will see it online as a rule of thumb: 60% salary, 40% distributions. It does not come from the IRS, the tax code or any court. A salary set by a ratio, rather than by what your work is worth, is hard to defend.

The IRS can reclassify distributions as wages. The S corporation then owes the employer and employee Social Security and Medicare taxes on the reclassified amount, plus penalties and interest.

The best-known case is David E. Watson, P.C. v. United States, decided by the Eighth Circuit in 2012. Mr. Watson, a CPA, paid himself a $24,000 salary in 2002 and 2003 through his S corporation while receiving far larger profit distributions. An IRS valuation expert put the market value of his services at about $91,044 a year. The court upheld treating that amount as wages. It looked at substance over form: what he actually did, his qualifications and what similar professionals earned.

Paying yourself nothing works only if you perform no services or only minor services for the company.

The IRS publishes a reasonable compensation job aid for its own valuation staff. It is not official IRS guidance, but it shows how an examiner may think. It describes three approaches:

• Market approach. What do similar companies pay people in similar roles? The job aid calls this the most commonly used method.
• Cost approach. List each task you do (clinical work, sales, management, bookkeeping), estimate the hours, and price each task at what you would pay someone else. Add it up. This often suits small, owner-run businesses where the owner wears many hats.
• Income approach. After paying your salary, would an outside investor still earn a fair return on the business? If profits are very high and salary is very low, the salary is likely too low.

How this plays out by profession:

• Dentists and physicians. Most profit comes from the owner's own clinical work, so a large share of it usually looks like pay for services. Compare against what a practice would pay an employed associate or hospitalist with your specialty and schedule, then add for management duties.
• Consultants and other solo professionals. When the owner is the only one producing revenue, little profit is left that is not tied to personal services. Market data for your role and billing level carries a lot of weight.
• Owners with a team. If staff produce much of the revenue, more of the profit may reflect the business itself, not your personal work. Document who produces what.

Best for: S corporation owners, including dentists, physicians, attorneys, consultants and other professionals, who want a salary they can explain and support.

1. Free initial consultation. We learn how your business earns money and what you do day to day.
2. Fees quoted upfront, in writing. Our fees are transparent and fair, and you see them before work starts.
3. We review your current salary, distributions, payroll reports and prior returns.
4. We apply the IRS factors and a cost or market approach to your facts, using current salary data.
5. We write a short memo that explains the salary and the data behind it, for your files.
6. We coordinate payroll changes and your quarterly estimates. See quarterly tax planning.

What to send us: last year's Form 1120-S and K-1, year-to-date payroll reports, a profit and loss statement, and a short list of your duties and typical weekly hours.