Trap 1 · The salary · From Chapter 9
Reasonable Compensation: The Salary That Defends the Election
Reasonable compensation is the adequate W-2 wage an S-corp must pay its shareholder-employees — judged by duties, hours, and comparable salaries. Pay too little and take the rest as distributions, and the IRS recharacterizes the difference as wages with payroll tax, penalties, and interest.
The test
Duties, hours, and comparable salaries. What would you pay a stranger to do your job? Courts weigh the work actually performed against market pay for similar roles — a full-time operator and a passive investor face very different numbers.
The recharacterization
Distributions above a defensible salary get reclassified as wages: payroll tax plus penalties and interest, assessed against the company that should have withheld. The savings invert into a bill.
Safe practices
Set the salary from a documented analysis before year-end, run real payroll from day one, and revisit the number as duties and profit change. The file you build in December is the defense you argue years later.
Trap questions, answered
- Is there a percentage rule, like 60/40?
- No IRS rule blesses any ratio. Courts weigh duties, time, and comparables — a ratio is a starting guess, not a defense.
- Can I take zero salary in a loss year?
- Losses change the math but not the duty: if you worked, some wage is usually defensible. Zero salary with full-time work and distributions invites audit.
- Who decides what's reasonable?
- You first, on a defensible analysis — then the IRS on exam, then a court if it goes that far. Document your number when you set it.
From the practice: Reasonable compensation, explained · S-corp vs LLC, compared
The other traps: Distributions vs Salary · S Election Eligibility · Built-In Gains Tax · Late S Election Relief