Is Your Compensation Reasonable? A Guide for C Corp and S Corp Business Owners
Setting your own salary as a business owner may seem straightforward—but if you’re operating as a C corporation or S corporation, the IRS is paying attention. Failing to pay yourself a “reasonable” salary could trigger tax reclassification, penalties, and unwanted audits.
Let’s break down what the IRS considers reasonable compensation and how to ensure your salary meets the standard.
How Salary Strategy Differs for C Corps vs. S Corps
C corporation owners often take higher salaries because they’re tax-deductible for the business, reducing the company’s taxable income. However, if the salary is too high relative to the actual work performed, the IRS may reclassify part of it as dividends, which aren’t deductible—resulting in higher taxes.
In contrast, S corporation owners often do the opposite: they take lower salaries and more in distributions, which aren’t subject to payroll taxes. But if the IRS thinks you’re underpaying yourself in wages, it can reclassify those distributions as taxable income—adding back taxes, interest, and penalties.
The bottom line? Whether you’re trying to reduce corporate taxes or payroll taxes, the IRS is watching. You need to back up your salary decisions with evidence of fair market value.
What Does the IRS Consider “Reasonable”?
The IRS defines reasonable compensation as what a similar business would pay someone else to perform the same job under similar conditions.
Here are key factors they evaluate:
- Your duties, responsibilities, and titles
- Your level of experience and training
- Time devoted to the business
- Business profitability
- Salaries paid in similar roles and industries in your region
It’s not just about what you think is fair—it’s about what you can justify based on objective data.
4 Ways to Document and Defend Your Salary
1. Research Industry Benchmarks
Use reliable salary databases (like the U.S. Bureau of Labor Statistics) or industry reports to compare your role to others in similar companies. Save this documentation to support your compensation decision.
2. Create a Job Description
Clearly define the work you do. If you’re wearing multiple hats—strategic planning, operations, client management—your salary should reflect that complexity.
3. Hold Formal Reviews and Meetings
Document salary decisions in board meeting minutes and formally approve compensation adjustments. This shows the IRS your process is compliant with corporate governance standards.
4. Review Compensation Annually
As your business evolves, so should your compensation. Conduct an annual review that takes into account business performance, industry trends, and your changing responsibilities.
Why It Matters
Getting your salary right isn’t just about IRS compliance—it’s about protecting your business from unnecessary scrutiny and aligning your compensation with your role. The good news? With the right documentation and a proactive strategy, you can stay on the right side of the tax code.
Need Help Establishing Reasonable Compensation?
Don’t wait for the IRS to come calling. We can help you determine fair salary benchmarks, develop documentation, and strengthen your position. Contact our team today to get started.
