← S-Corp Reasonable Compensation Calculator

Why does the IRS test your S-corp salary?

An S-corp doesn't pay corporate income tax on its profit — it passes through to the shareholder's own return. That makes the split between "W-2 salary" and "distribution" matter more than it would in a regular C-corp, because only the salary portion is subject to employment tax. Here is why the IRS watches that split, what the leading case actually decided, and why there is no shortcut percentage that makes the question go away.

Open the free reasonable-compensation calculator

The incentive the rule exists to police

Salary is subject to combined Social Security and Medicare tax (FICA) — 15.3% combined up to the year's Social Security wage base, 2.9% above it. A distribution from an S-corp's profit is not subject to FICA at all. So every dollar an owner recategorizes from "salary" to "distribution" saves roughly 15 cents in employment tax, with no change to income tax. That gap, not the S-corp structure itself, is what the reasonable-compensation rule is built to close.

Watson v. Commissioner, in brief

David Watson was a CPA and the sole shareholder-employee of his own accounting firm, organized as an S-corp. Over the two years at issue, the firm's profit ran approximately $200,000–274,000, and Watson paid himself exactly $24,000 in W-2 salary each year, taking the remainder as distributions. The Tax Court, upheld by the Eighth Circuit (668 F.3d 1008 (8th Cir. 2012)), compared his pay to what an accountant of his experience would earn at a competing firm and to what his own firm would have had to pay to replace him, and found $24,000 unreasonable. It recharacterized $67,044 of each year's distributions as wages — creating a back payroll-tax assessment, plus penalties and interest, on money Watson had already spent as a distribution.

Why the "60/40 rule" is a myth

Advisor blogs and forum posts sometimes describe a "60/40 rule" — 60% of profit as salary, 40% as distribution — or similar percentage guidelines. The IRS has never published a safe-harbor percentage of any kind. Following a percentage rule does not itself establish that a salary is reasonable, and a salary that happens to match one is judged on the same comparable-wage facts as any other. Treat a percentage figure as a rough sanity check at most, never as documentation.

What the actual test looks at

Rev. Rul. 74-44 and the cases applying it (Watson; Sean McAlary Ltd. v. Commissioner; Glass Blocks Unlimited v. Commissioner) weigh a facts-and-circumstances test, not a formula: training and experience, the actual duties performed, time and effort devoted to the business, dividend history, what the business pays non-owner employees, the timing and manner of any bonus, what comparable businesses pay for similar services, and whether a documented formula or agreement sets compensation. The comparable-wage factor — what an unrelated employer would pay someone else for this job — is the one every reported case leans on most heavily, which is why this tool's calculator asks you to supply that figure directly rather than estimating it for you.

Distributions are not the problem — an artificially low salary paired with one is

Nothing about the reasonable-compensation rule discourages distributions after a defensible salary is paid; that split is a normal, expected feature of the S-corp structure and often the whole reason an owner chooses it. The exposure sits specifically in a salary set low enough, next to a distribution large enough, that the pattern reads as pay recharacterized to dodge FICA — the exact fact pattern in every reported adjustment case.

Common questions

Why does the IRS care how I split S-corp pay between salary and distributions?

Because the split changes how much employment tax is owed. Salary is subject to combined Social Security and Medicare tax (FICA), currently 15.3% combined up to the annual Social Security wage base and 2.9% above it. Distributions from an S-corp are not subject to FICA at all. An owner who calls most of their pay a "distribution" instead of salary can significantly understate their employment tax bill, which is exactly the incentive the reasonable-compensation rule exists to police.

What did Watson v. Commissioner actually decide?

David Watson, a CPA and the sole shareholder-employee of his accounting firm's S-corp, paid himself a $24,000 W-2 salary in each of two years while the firm's profit ran roughly $200,000–274,000, taking the rest as distributions. The Eighth Circuit upheld the Tax Court's finding that $24,000 was not reasonable compensation for a CPA of his experience doing that work, and recharacterized $67,044 of each year's distributions as wages — creating a back payroll-tax bill plus penalties and interest.

Is there an IRS safe-harbor percentage for S-corp salary, like 60% of profit?

No. The IRS has never published a safe-harbor percentage. The "60/40 rule" and similar percentage guidelines that circulate in online forums and some advisors' marketing are informal rules of thumb, not IRS guidance, and following one does not itself establish that a salary is reasonable.

What test does the IRS and the courts actually use?

A multi-factor, facts-and-circumstances comparable-wage test, drawn from Rev. Rul. 74-44 and applied in cases like Watson, Sean McAlary Ltd., and Glass Blocks Unlimited: what would an unrelated employer pay someone else to do this specific job, for these specific hours, weighed alongside training and experience, duties, dividend history, pay to other employees, and whether compensation follows a documented formula or agreement.

Does the reasonable-compensation rule mean I should never take distributions?

No. Distributions after a reasonable salary is paid are a normal, expected part of the S-corp structure and the reason many owners choose it. The rule targets a salary set artificially low specifically to shrink the FICA base while a much larger distribution is paid alongside it — not the existence of a distribution itself.