The S-Corp Salary Trap: Are You Paying Yourself the Right Way?

The S-Corp Salary Trap: Are You Paying Yourself the Right Way?

If you own an S-Corporation—or are considering converting your business into one—understanding how to pay yourself properly isn’t just good accounting practice. It can make or break your tax strategy. Many business owners form an S-Corp to reduce self-employment taxes, but few realize there’s a fine line between a smart tax move and an IRS audit trigger. That line is called “reasonable compensation.”

Here’s how it works: Unlike a sole proprietorship or single-member LLC, an S-Corp allows you to split your income into two parts—a salary (subject to payroll taxes) and a shareholder distribution (not subject to self-employment tax). This structure can save thousands each year in Social Security and Medicare taxes. But here’s the catch: the IRS requires that your salary be “reasonable compensation” for the work you do. If you underpay yourself to avoid payroll taxes, you're asking for trouble.

So what’s considered “reasonable”? It depends on several factors, including industry standards, your duties, hours worked, experience, and the size and profitability of your business. The IRS has cracked down on business owners who take little to no salary while pulling large distributions—flagging it as a red flag for abuse.

On the flip side, overpaying yourself also hurts. If you pay too high a salary, you end up handing more to the IRS in payroll taxes than necessary, eroding the benefit of the S-Corp election. The sweet spot is finding a salary level that meets IRS guidelines while allowing for maximum tax-efficient distributions.

One smart approach is to benchmark salaries for similar roles in your industry. Tools like the Bureau of Labor Statistics, job boards, or professional compensation surveys can help provide a defensible number. And documenting your reasoning with job descriptions, time logs, or third-party reports can help if the IRS ever comes knocking.

Ultimately, the goal is balance. You want to protect your S-Corp tax benefits without attracting unwanted scrutiny. Working with a CPA or tax advisor who understands the nuances of S-Corps is critical. They can help you structure your compensation in a way that optimizes savings and keeps you compliant.

Bottom line: The S-Corp structure can be a powerful tool to reduce taxes—but only if you pay yourself properly. Don’t fall into the salary trap. Know your numbers, document your reasoning, and make sure your compensation is both smart and defensible.

Stay empowered & stay protected,
Wealth Protection Alliance