If you own a C corp or S corp, getting your salary right isn’t just about paying yourself fairly—it’s about staying on the IRS’s good side. Pay yourself too much or too little, and you could face penalties, back taxes, and interest charges.
Why Your Salary Matters to the IRS
The IRS watches business owner salaries closely because they’re often used to minimize taxes. Here’s what typically happens:
C Corporation Owners often pay themselves big salaries because salaries are tax-deductible business expenses. Higher salary = lower corporate taxes. But if your salary is way more than what the work is worth, the IRS might say “that’s really a dividend” and take away the deduction.
S Corporation Owners usually do the opposite—they take small salaries and big distributions. Why? Because distributions don’t get hit with payroll taxes, while salaries do. But if your salary is unreasonably low, the IRS might reclassify some of those distributions as wages and stick you with back payroll taxes.
What “Reasonable” Actually Means
The IRS defines reasonable compensation as what you’d normally pay someone else to do the same job under similar circumstances. Think of it this way: if you hired an outsider tomorrow to do your exact job, what would you pay them?
The IRS looks at five key things:
- What you actually do day-to-day
- Your skills and experience
- How much time you spend working
- What similar businesses pay for comparable roles
- How well your business is doing financially
How to Get Your Compensation Right
1. Do Your Homework
Look up what other companies pay for jobs like yours. Check salary surveys, industry reports, and government data (the Bureau of Labor Statistics is a great free resource). Save everything you find—this paperwork shows the IRS you made informed decisions, not random guesses.
2. Write Down What You Do
Create a detailed job description that covers all your roles. Are you the CEO making big strategic decisions? Do you handle day-to-day operations? Are you also the IT person, bookkeeper, and janitor? The more jobs you do, the stronger your case for higher pay.
3. Make It Official
Don’t just decide your salary over coffee. Hold actual board meetings, discuss compensation, and record the decisions in meeting minutes. This shows the IRS you followed proper business procedures.
4. Review Annually
Your salary shouldn’t be set-and-forget. Review it every year with your Padgett advisor and adjust based on how the business is doing, changes in your workload, or shifts in industry pay rates. Keep notes about why you made any changes.
The Bottom Line
Getting your compensation right protects you from IRS problems and supports your overall business strategy. It’s not a one-time decision—you need to stay on top of it as your business grows and changes.
If you’re unsure about your current salary or need help setting up a compensation review process, consider working with a Padgett advisor who can help you benchmark your pay and document everything properly. We stay up to dat eon the rules to help you make the most informed decisions.