Ask five business owners how to set S-Corp salary and at least three will tell you the same thing: pay yourself 60%, take the rest as distributions. It sounds official. It has never once been IRS guidance.
There's no formula at all, but that doesn't mean there's no answer, and getting it wrong is a lot more expensive than most owners realize.
The rule that isn't a rule
Pay yourself 60% salary, take 40% as distributions.
Reasonable compensation — what an unrelated person would be paid for the same work.
The "60/40 rule" gets repeated so often in small business forums and even by some preparers that it's treated as settled law. It isn't. The IRS has never published this ratio, never endorsed it, and has successfully challenged plenty of S-Corp owners who followed it to the letter. It's practitioner shorthand that calcified into myth.
What the IRS actually requires is simpler to state and harder to calculate: reasonable compensation, the amount an unrelated person would be paid for performing the same services, in the same role, in a similar business. No percentage. No formula. A facts-and-circumstances test. If you're still deciding whether the election is worth making, see S-Corp Election for Maryland LLCs.
What the IRS actually looks at
The IRS's own Reasonable Compensation Job Aid, used by examining agents, and the Tax Court decisions built on it point to the same handful of factors every time.
Training and experience
A 20-year specialist commands more than someone a year into the field, regardless of what the business nets.
Duties and time devoted
CEO, lead technician, and the person answering phones? Your salary should reflect all three roles.
Comparable salaries
What would this exact job cost to hire out? Typically the most heavily weighted factor.
Distribution history
A pattern of large distributions next to a token salary is exactly what draws attention.
Company size & profitability
A business generating $800,000 with a $40,000 officer salary is, on its face, a red flag.
Non-owner pay
Paying a manager $70,000 for less responsibility than you carry works against a lower owner salary.
A second lens courts have applied is the independent investor test: would a hypothetical outside investor be satisfied with their return after your salary is paid? If compensation eats the entire profit, that's its own red flag, pointed the opposite direction.
The case that changed everything
The court's reasoning wasn't complicated: a working CPA generating that kind of income could not credibly be worth only $24,000 to hire.
Compensation should generally land at or above roughly 70% of what the comparable market rate for the work would actually cost.
That number isn't a ratio, it's a floor. Below it, the burden of proof gets steep fast.
Two ways to get it wrong, not one
Most conversations only mention paying yourself too little. There's a real cost on the other side too.
The right number isn't the lowest defensible one or the highest comfortable one — it's the accurate one. For the full salary-versus-distribution picture across every structure, see How to Pay Yourself as a Business Owner.
Why this matters more now that QBI is permanent
A lower salary means more profit flows through as qualified business income eligible for that 20% deduction — now a permanent incentive. That's a legitimate reason salary optimization matters, and exactly why enforcement has followed. See our full breakdown of the QBI deduction.
How to document a defensible number
The biggest difference between owners who sail through an inquiry and owners who don't is whether the decision was documented before the return was filed.
- 01
Pull wage data
BLS occupational wage data for your role and region.
- 02
Write a job description
What you do, hours, and every role you carry.
- 03
Put it in writing
A dated compensation memo or meeting minutes.
- 04
Revisit yearly
Defensible at $100K profit can look indefensible at $400K.
The S-Corp and retirement connection
Both a Solo 401(k) and a SEP-IRA calculate the employer contribution off your W-2 wages, not total business profit — so an artificially low salary quietly caps your retirement savings while it saves payroll tax. We walk through that tradeoff in Solo 401(k) vs. SEP-IRA, and how it changes as the business grows.
Bring us your numbers. We’ll run a real comparable-wage analysis for your role and industry, tell you honestly where you stand, and help you document it before it’s ever a question.
Frequently asked questions
Correct. The IRS has never published or endorsed a 60% salary, 40% distribution ratio. The actual standard is reasonable compensation, based on comparable wages and the specific facts of your role.
