Determining reasonable compensation is a critical issue for owners of C corporations and S corporations. If your salary doesn’t align with IRS standards, the agency may reclassify payments or disallow deductions—potentially leading to penalties, back taxes, and interest.
To protect your business and remain compliant, it’s essential to understand what the IRS considers a reasonable salary and take proactive steps to document and justify your compensation.
How Compensation Strategies Differ Between C and S Corporations
Owners of C corporations often pay themselves higher salaries because wages are tax-deductible, reducing corporate taxable income. But if a salary is excessive relative to job duties, the IRS may reclassify part of it as non-deductible dividends, increasing your tax liability.
In contrast, S corporation owners may minimize wages and maximize distributions, since distributions are not subject to payroll taxes. However, the IRS closely monitors this strategy. If it finds that an owner’s salary is unreasonably low, it can reclassify some distributions as wages—resulting in back payroll taxes and penalties.
No matter the structure, the IRS expects fair market compensation that reflects the value of work performed.
What the IRS Considers “Reasonable Compensation”
The IRS defines reasonable compensation as “the amount that would ordinarily be paid for like services by like enterprises under like circumstances.” In other words, your salary should reflect what a third party would be paid for similar work in your industry and region.
To determine whether an owner’s salary is reasonable, the IRS reviews several key factors:
- Job duties and responsibilities
- Training, skills, and experience
- Time and effort devoted to the business
- Comparable salaries in the same industry and geographic area
- The business’s gross and net income
C and S corporation owners should regularly evaluate these elements and document their rationale. If compensation is ever questioned, having this data on file will strengthen your case.
How to Establish and Support Reasonable Compensation
To avoid IRS scrutiny and ensure your salary is compliant, business owners should take the following steps to establish and document reasonable compensation:
1. Conduct Market Research
Use industry salary surveys, compensation databases (such as the U.S. Bureau of Labor Statistics), and local benchmarks to determine what similar roles pay. This helps demonstrate that your pay is based on objective market data—not just personal preference.
✅ Tip: Save your research findings to support your compensation decisions in case of an IRS audit.
2. Create a Detailed Job Description
Outline your specific roles and responsibilities within the business. Are you acting as CEO, sales lead, and operations manager? The more hats you wear, the more justification you have for a higher salary.
3. Maintain Formal Corporate Records
Hold regular board meetings and document all compensation decisions in meeting minutes. This formal approval process reinforces that your pay was set appropriately and with oversight.
4. Perform and Record Annual Compensation Reviews
Each year, reassess your salary to reflect:
- Changes in profitability
- Shifts in your responsibilities
- Market trends or industry benchmarks
Keep a record of the review process and the rationale for any changes. This demonstrates that your compensation is adjusted in good faith, not arbitrarily.
Make Reasonable Compensation an Ongoing Priority
Setting reasonable compensation isn’t a one-time task—it requires ongoing attention and documentation. IRS scrutiny around owner salaries in C and S corporations remains high, especially when compensation strategies are used to reduce taxes.
By benchmarking your salary, keeping proper records, and conducting regular reviews, you can:
- Strengthen your compliance position
- Reduce the risk of IRS penalties
- Support broader financial and tax strategies for your business
Need Help Determining Reasonable Compensation?
Whether you’re a C corporation owner aiming to avoid excessive salary classifications or an S corporation owner balancing wages and distributions, we can help. Our team can:
- Benchmark your compensation against industry standards
- Draft proper documentation
- Guide you through an IRS-compliant compensation strategy
👉 Contact us today to schedule a consultation and ensure your salary meets IRS guidelines.
Originally published April 21, 2021. Updated May 2025.