S-Corp Owner Payroll: Reasonable Compensation Explained
Your S-corp saves you self-employment tax by splitting profit between W-2 wages and distributions. The IRS knows the incentive — pay yourself as little salary as possible — and audits this specifically. Here's how to stay defensible.
The rule
S-corp owner-employees must be paid 'reasonable compensation' for services rendered before taking distributions. Reasonable = what someone else would be paid to do your job in your industry and geography.
There is no bright-line formula in the tax code. The IRS looks at facts and circumstances.
How the IRS evaluates it
Training and experience. Duties and responsibilities. Time and effort devoted to the business. Comparable pay for similar services in similar businesses in the same geography. Payment history. What comparable non-owner employees are paid.
In the leading cases (Watson, Herbert V.), courts have accepted salaries well below what an owner drew — but only when properly documented.
How to document a defensible number
Use a reputable data source — RCReports, ERI, BLS OES data, or an industry salary survey — for your role, industry NAICS code, and Montana geography.
Save the report in your permanent tax file. Re-run annually.
Don't just copy last year's number. Growth and role changes matter.
The rules of thumb (imperfect but useful)
Service business, owner does most of the revenue-producing work: salary = 40–60% of profit is a common range.
Business with employees doing the work, owner is manager/owner: salary = 20–40% of profit.
Very high-profit businesses (over $500k profit) often have salaries in the $150k–$250k range — beyond that, additional profit legitimately looks like return on capital and business systems, not labor.
These are starting points, not rules. Use real data.
What happens in an audit
The IRS reclassifies distributions as wages, assesses back FICA (both halves), plus penalties and interest. It's expensive.
A documented RCReports figure and payroll history that matches it is usually enough to end the discussion.
A quick disclaimer
This article is general information for Montana small business owners, not tax, legal, or accounting advice for your specific situation. Rules change, and how they apply depends on facts we don't know about you. Before acting on anything you read here, talk to a qualified professional. If you're a Montana business owner and want a real conversation about your books, payroll, or tax, that's what Marlow Accounting is here for — call 406-290-1214 or schedule a discovery call.