Last month, a client reached out with a common (and slightly panicked) question:

 "I think I'm paying myself a salary... but I’m not totally sure? I just transfer money from my business account when I need it. Does that count?"

If that sounds familiar, you're not alone.

Many S-Corp owners believe they’re meeting requirements, only to find out they’re not actually running payroll, documenting compensation, or making the most of their tax advantages.

"Reasonable compensation" isn’t just about IRS compliance. It’s a powerful and often overlooked tax strategy that helps you:

• Maximize take-home pay
• Preserve the 20% QBI (Qualified Business Income) deduction
• Avoid excessive self-employment taxes
• Reduce audit risk
• Build a sustainable compensation framework

If your business earns more than $50K annually, dialing in your salary isn’t optional, it's essential. Let’s break it down.
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‍What Is "Reasonable Compensation"?

Imagine you own an ice cream shop. You scoop cones, manage staff, oversee marketing, and run finances.

Each role has a fair market wage. You’d pay a store employee one rate, a manager another, and an executive-level operator something more.

As an S-Corp owner, you're required to pay yourself a fair W-2 salary before taking any profit distributions. That salary must reflect the value of the work you perform. You can't just take all your profits as distributions and call yourself compliant.

If your salary is too low:

• You risk penalties and back taxes
• You could lose your QBI deduction
• You’re likely underreporting income for Social Security, retirement contributions, and even financing applications

Understanding Distributions And Why They're Not Free Money

S-Corp distributions are the profits you take home after you’ve been paid a reasonable salary.

• Salary = subject to income tax + payroll tax (15.3% employer + employee combined)
• Distributions = subject to income tax only (no payroll tax)

Example: If your S-Corp has $100,000 in profit

Option 1 (All Salary):

• $100,000 salary
• Payroll taxes = $15,300

‍Option 2 (Salary + Distributions):

• $60,000 reasonable salary
• $40,000 distributions
• Payroll taxes = $9,180 (only on salary)
• Tax savings = $6,120 annually

Advantage: You save payroll tax, but only after your salary passes the “reasonableness test.”

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Build a Defensible Compensation Strategy in Three Steps

1. Research comparable salaries (60% of your determination)
   Use BLS.gov, Salary.com, job board data, and industry benchmarks
   
   
2. Document your responsibilities (25% of your determination)
   Outline all roles you fill in your business and estimate hours spent on each
   
   
3. Factor in business considerations (15% of your determination)
   Include size, location, profitability, and how many employees or contractors you manage.

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Strategic Bonus: Use Salary to Unlock the QBI Deduction

If you're above the 2024 QBI income thresholds ($191,950 single / $383,900 married), your 20% pass-through deduction begins to phase out. To keep it, you must pay enough in W-2 wages.

In other words: Setting your salary properly keeps the IRS happy and activates a valuable tax break.

In most cases, owners get the best result by paying a balanced, reasonable salary that meets QBI eligibility while still leveraging distributions.

The Most Common Compensation Mistakes

 ❌ Setting Salary Below Market
❌ Inconsistent or random salary/distribution payments
❌ Taking only distributions (and zero W-2 salary)
❌ Copy-pasting salary across multiple businesses, regardless of role
❌ Setting salary exactly at Social Security wage base without justification

📌 Fix: Use real benchmarks, align comp with responsibilities, and document annually.

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Your Reasonable Compensation Action Plan

 ✅ Research salary data using platforms like BLS.gov or Salary.com
✅ Document your job roles and time allocation
✅ Draft a compensation policy, reviewed annually
✅ Set up payroll (we recommend Gusto)
✅ Work with a tax pro to model QBI eligibility + payroll tax tradeoffs

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The Bottom Line

Reasonable compensation isn’t about finding the lowest number the IRS might “accept.” It’s about hitting the sweet spot between tax savings and long-term sustainability, especially when factoring in the QBI deduction.

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Key Takeaways:

• You must pay yourself a W-2 salary that reflects your workload
• Distributions are a tax-advantaged bonus, not a salary replacement
• Smart compensation planning maximizes both QBI deductions and take-home savings
• The right strategy helps you sleep better at night, while keeping more money in your pocket

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