What counts as a reasonable S corp salary for an owner?

The short answer

An S corporation has to pay a shareholder who works in the business reasonable compensation, as W-2 wages, before non-wage distributions. The IRS can reclassify distributions as wages, and assess payroll tax, if the salary is too low. There is no formula in the statute. The IRS lists factors: your duties, the time you spend, and what comparable businesses pay for similar work.

A related page on how that salary interacts with the 401(k) dollar caps is S corp salary and 401(k) limits. The contribution math for 2026 and the 2027 forecast is in solo 401(k) contribution limits.

What does the IRS look at?

The IRS page on S corporation compensation and medical insurance issues lists factors that include:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Distribution history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

The same page frames the question by the source of the gross receipts. Revenue from your personal services points toward wages. Revenue from other employees and from equipment can support distributions. A firm that is mostly the owner's own billable time is not in the same place as a firm with a staff and a plant.

What happened in the Watson case?

In David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), an accountant paid himself a $24,000 salary and took the rest of the firm's profit as distributions. The court upheld the IRS view that reasonable pay was $91,044 a year and treated the difference as wages subject to employment tax. The dollar figures are from that case. They are not a safe-harbor salary for a different owner in a different year. They are the illustration courts and examiners still cite when a salary is nominal next to the profit.

How does salary drive tax and a retirement plan?

The 2027 401(k) salary of $198,000 is the Milliman and Marsh forecast described on the solo 401(k) page. It is not an IRS limit. The Social Security wage base of $192,300 for 2027 is the SSA figure.

What does a higher salary cost in payroll tax?

Hypothetical, for illustration only. Ruth's S corporation has $400,000 of profit before her salary. She is considering a 2027 W-2 salary of $198,000 instead of $150,000, a raise of $48,000, because $198,000 is the forecast wage that fills the forecast annual additions cap at a 25 percent employer contribution. Whether $198,000 is reasonable for her role is a separate question, and it comes first. This arithmetic only prices the payroll tax on the extra wages.

The 2027 wage base is $192,300. Social Security tax applies to the $42,300 of the raise that falls between $150,000 and $192,300. Combined employer and employee Social Security tax is 12.4 percent of $42,300, or $5,245.20. Medicare tax at 2.9 percent applies to the full $48,000, or $1,392. Together that is $6,637.20, about $6,637, before the company's income-tax deduction for the employer share.

At 25 percent of W-2 pay, a $150,000 salary supports an employer 401(k) contribution of $37,500. A $198,000 salary supports $49,500. Both of those employer amounts still have to fit under the annual additions limit after her employee deferral, and the $198,000 and $49,500 pair is only as real as the 2027 forecast. The 2026 official pair, a $190,000 salary and a $47,500 employer contribution on top of a $24,500 deferral, is the one in Notice 2025-67 and the COLA table. The worked version is on the solo 401(k) page.

Additional Medicare Tax of 0.9 percent is not in the $6,637. It applies to the employee, not as a combined 12.4-style figure, once wages pass $200,000 for a single filer or $250,000 for a joint return. A salary of $198,000 stays under the single threshold. A household that is already over the joint threshold from other wages is a different return.

The bottom line

Reasonable compensation is a facts test, not a percentage. The IRS factors are duties, time, comparables, and where the revenue came from. Watson shows what a court did with a $24,000 salary against $91,044 of pay it accepted as reasonable. Salary then drives payroll tax up to the wage base, $184,500 in 2026 and $192,300 in 2027, and it drives how large a 25 percent employer 401(k) contribution can be. Setting the wage to hit a retirement cap does not make the wage reasonable.

If you wrote down the salary before you wrote down the job, which of the IRS factors would you actually have an answer for?

Document the pay with your CPA. The 2027 figures, which are a forecast and not an IRS limit, are on solo 401(k) limits, the 2027 forecast. The wage that fills the cap, and the payroll tax on it, is on the S corp salary that fills a solo 401(k). Run the 2026 limits in the owner retirement plan calculator. If a sale is the reason the salary is being reset, run the price through the business sale calculator. Durham owners can start from the financial advisor in Durham, NC page, and the owner lessons hold the longer path.

Questions people ask next

Is there a standard percentage, such as 60/40, between salary and distributions?

No. No IRS rule sets a percentage split. The factors on the IRS S corporation compensation page are what get examined: training, duties, time, what comparable firms pay, and how the gross receipts were earned.

Does health insurance count as wages?

Premiums an S corporation pays for a more-than-2-percent shareholder are reported as W-2 wages in Box 1. When they are paid under a plan for employees, they are generally not subject to Social Security and Medicare tax. The IRS compensation page states that reporting rule.

How does salary change a solo 401(k)?

For a corporate owner, the employer contribution is generally limited to 25 percent of W-2 pay. A higher reasonable salary can raise that contribution. It does not, by itself, prove the salary is reasonable.

What happens if the salary is too low?

The IRS can reclassify distributions as wages and assess employment tax, penalties, and interest. Watson is the case owners hear about: a $24,000 salary was increased to $91,044 for employment-tax purposes.