Quick answer
If you own an S-corp and work in it, the IRS requires you to take reasonable compensation as W-2 wages before taking distributions. Reasonable means roughly what the business would pay someone else to do your job.
There is no IRS formula or safe percentage. Common approaches are the market method (what similar jobs pay), the cost method (pricing each role you perform) and the income method (what’s left for the owner’s capital and non-labor sources).
Pay too little and the IRS can reclassify distributions as wages, with back payroll taxes, interest and penalties. Document how you chose your number.
Why the salary matters
An S-corp saves payroll tax because distributions aren’t subject to Social Security and Medicare tax. The salary is. So every dollar you move from salary to distributions saves 15.3% (up to the 2026 Social Security wage base of $184,500, then 2.9%).
That’s exactly why the IRS watches low salaries. Its guidance says S-corps must pay reasonable compensation to shareholder-employees for services before making non-wage distributions.
What the IRS and courts look at
The IRS lists the factors courts have used:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend (distribution) history
- Payments to non-shareholder employees
- Timing and manner of bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- Use of a formula to set pay
The IRS also looks at the source of gross receipts. Income that comes from your personal services should mostly be wages. Income from employees you hire or from equipment and capital can support larger distributions. For a solo freelancer, nearly all revenue comes from your own work.
A case to know
In David E. Watson, P.C. v. United States (8th Cir. 2012), an accountant paid himself $24,000 a year while his firm earned far more. The court agreed with the IRS that about $91,000 was reasonable and upheld back employment taxes. The lesson: a token salary for a skilled professional doesn’t hold up.
Three ways to set your salary
1. Market method
Find what employers pay for your role in your area. Good sources include the Bureau of Labor Statistics Occupational Employment and Wage Statistics data, salary surveys from industry groups and job listings. Adjust for your hours: if you work 30 hours a week, prorate.
2. Cost (many hats) method
List each role you perform and what you’d pay to outsource it. A freelance designer might spend 70% on design, 20% on sales and client management and 10% on admin. Price each at market rates and add them up.
3. Income method
Start from profit and subtract a fair return on anything that isn’t your labor: employees, contractors, equipment or intellectual property. This suits businesses with staff more than solo freelancers.
What about the 60/40 rule?
Many advisers use 60% salary and 40% distributions as a rough starting point. It is a rule of thumb, not IRS guidance. For a solo service business, market data should drive the number, not a ratio.
Worked example: a web developer with $140,000 profit
Leo runs a one-person web development S-corp. Before his salary, the business earns $140,000. His research on developer pay in his city and his 40-hour weeks points to about $80,000 as defensible.
| Salary choice | Payroll tax (15.3%) | Distributions | Payroll tax saved vs $140,000 of SE tax ($19,781) |
|---|---|---|---|
| $40,000 | $6,120 | $100,000 | $13,661 (high audit risk) |
| $60,000 | $9,180 | $80,000 | $10,601 |
| $80,000 | $12,240 | $60,000 | $7,541 |
The $80,000 salary still saves about $7,500 a year before S-corp costs, and it rests on market data. The $40,000 salary saves more on paper but is hard to justify for a full-time developer. Figures ignore the employer tax deduction, QBI effects and state taxes.
Leo also notes that a higher salary lets him make larger Solo 401(k) employer contributions, which are based on W-2 wages.
How to run the salary
- Pay yourself through payroll, with federal and state withholding. Payroll services start at around $40 to $60 a month.
- Pay regularly, monthly or twice a month, not one lump sum in December.
- File quarterly Form 941, annual Form 940 and issue yourself a W-2.
- Take distributions only after salary is current.
- If profit drops, you can lower the salary, but keep it reasonable for the work you do.
Health insurance
For owners of more than 2%, the S-corp can pay your health insurance premiums. They go in Box 1 of your W-2 as wages but aren’t subject to Social Security or Medicare tax. You may then claim the self-employed health insurance deduction.
Document your decision
Keep a short memo in your records each year:
- Your job duties and weekly hours.
- The market data you used, with dates and sources.
- How you prorated or combined roles.
- The salary you chose and why.
A board or member resolution approving the salary adds support. If the IRS asks, this file is your defense.
Frequently asked questions
Can I pay myself no salary in a loss year?
If the business has no profit and you take no distributions, a zero salary can be reasonable. Salary requirements bite when you take money out.
Is there a minimum salary percentage?
No. The IRS doesn’t publish one. Base the salary on what the work is worth.
Can distributions exceed my salary?
Yes, if your salary is reasonable. Businesses with employees or capital can often support larger distributions than a solo service provider.
What happens if the IRS says my salary was too low?
It can reclassify part of your distributions as wages and assess payroll taxes, interest and penalties for the open years.
This article is general information, not tax advice. Consult a CPA or Enrolled Agent for your situation.
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- How to Start an LLC in Texas
About this guide
Written by the Freelancer Tax HQ editorial team, based on our professional experience, official US government sources (IRS, SSA and other agencies) and reputable informational articles listed in the sources below. Last reviewed on . Tax rules change often, and we update this guide when they do. Read our editorial policy or report an error.
Sources
IRS: S Corporation Compensation and Medical Insurance Issues; Journal of Accountancy: Eighth Circuit agrees that CPA was underpaid; SSA: Contribution and Benefit Base; BLS: Occupational Employment and Wage Statistics. Example figures are FreelancerTaxHQ illustrations.
Official resources linked in this guide: IRS: Tax preparer credentials.