How Much Should You Pay Yourself? The S-Corp Salary Rule That Survives an Audit

If you own an S corporation, there's one question you probably ask your accountant every year: how much do I actually have to pay myself?

You want the answer to be "as little as possible" — because the lower your salary, the less payroll tax you pay. The IRS wants the answer to be "a reasonable amount" — because a salary that's too low is one of the easiest things for them to catch and reverse.

Both sides are right, and the good news is there's a number that keeps everybody happy. Here's how to find it, and how to write it down so it holds up if anyone ever asks.

Why the number matters so much

When you run your business as an S corp, your profit splits into two buckets:

• Salary — your W-2 wages, which get hit with payroll tax (Social Security and Medicare) of 15.3%.

• Distributions — the rest of the profit, which you pull out with no payroll tax at all.

That's the whole game. Every dollar you move from "salary" to "distribution" saves you about 15 cents in payroll tax — at least up to a point (more on the cap in a second). A sole proprietor doesn't get to play: they pay self-employment tax on essentially all of their profit (technically about 92% of it), with only the salary-sized piece sheltered when you switch to an S corp.

So why not set your salary at $1 and take everything else as a distribution? Because the IRS requires S-corp owners who actually work in the business to take reasonable compensation — a real salary for the real work you do — before you take distributions.

This isn't a gray area; the IRS has spelled it out for decades (Revenue Ruling 74-44 and its S-corp fact sheet). Pay yourself too little, and the IRS can reclassify your distributions as wages, then send a bill for the back payroll taxes plus penalties and interest. How big that bill gets varies widely. When a relief provision in the law (IRC §3509) applies, the tax piece can be held to roughly 10–14% of the reclassified wages, plus federal unemployment tax. But when that relief isn't available — the rules were intentionally disregarded, or several years get caught at once with penalties and interest stacking up — the total can approach or even exceed 40% of the amount reclassified. Whether the relief applies depends on your specific facts, which is exactly why this isn't a corner worth cutting.

The move, then, isn't "pay yourself as little as possible." It's "pay yourself a reasonable number you can back up with data."

The 2026 numbers that shape your decision

One detail makes a big difference: the Social Security piece of that 15.3% (which is 12.4% of it) only applies up to the wage base — $184,500 for 2026. Above that, your salary only carries the 2.9% Medicare piece.

What that means in plain terms: your biggest savings come from the profit between your salary and about $184,500. Below the cap, shifting a dollar to distributions saves the full 15.3%. Above it, you're only saving 2.9%, so the payoff shrinks. (One more thing at the top end: wages and self-employment income above $200,000 — or $250,000 if you're married filing jointly — pick up an extra 0.9% Medicare tax.) If your profit is well into six figures, the salary decision is less about Social Security tax and more about the QBI deduction — more on that below.

How to actually pick your number

Guessing a round number is the fastest way to lose an audit. "$50,000 because it felt about right" has no defense. And ignore the "60/40 rule" you may have heard — the idea that a 60% salary / 40% distribution split is automatically safe. The IRS has never blessed any such formula. Here are the two methods that actually work.

If you wear a lot of hats (most solo owners): Add up the jobs you actually do. A Westfield salon owner might spend 60% of her week cutting hair, 25% managing and doing the books, and 15% on marketing. Price each of those roles using real wage data, weight them by your time, and you've built a salary you can explain line by line.

If you mostly manage (you have staff doing the work): Ask what you'd have to pay someone else to run your business in your place — a general manager for a company your size, in your industry, in central Indiana.

Either way, the key is to anchor the number to real data, not a gut feel. The best free source is the Bureau of Labor Statistics wage data for the Indianapolis metro area. Look up your occupation, note the median and the range around it, and save the page. Here are a few examples for our area:

Your role	Typical local salary (median)
General / operations manager	~$108,000
Construction manager	~$100,000
First-line construction supervisor	~$80,000
Accountant	~$77,000
Electrician	~$65,000

A good rule of thumb: land somewhere in the median-to-upper-middle range for what you do. That's a number a reasonable person — or an auditor — would look at and nod.

(These are metro-wide medians from the BLS May 2023 survey, rounded. The Indianapolis metro was renamed "Indianapolis-Carmel-Greenwood" starting with the 2024 data, and the figures tend to drift up a little each year — so pull the current numbers when you set yours. They're also all-industry averages, so weight them toward your own experience and hours.)

A realistic example

Say you run a contracting business in Hamilton County as an S corp, and after expenses it clears $200,000 in profit.

You look up "construction manager" and set your salary at $85,000 — squarely in the local range for the work you do.

• Payroll tax on the $85,000 salary: about $13,000.

• After that salary and the payroll tax the business pays on it, roughly $108,000 is left to take as a distribution: $0 payroll tax on that piece.

As a sole proprietor, nearly all of that $200,000 would have been hit with self-employment tax. Running it through the S corp with a defensible salary saves you roughly $15,000 in payroll tax that year — money that stays in your pocket instead of going to Washington. (That's the payroll-tax savings before income taxes; your exact number depends on your salary and profit. It's an illustration, not a promise.)

The one wrinkle for higher earners: the QBI deduction

If your household taxable income is climbing past about $201,750 (single) or $403,500 (married filing jointly) for 2026, there's a twist worth knowing.

The 20% Qualified Business Income (QBI) deduction — which the 2025 One Big Beautiful Bill made permanent — starts phasing in an extra limit once you're above those income levels: your deduction gets tied to how much you pay in W-2 wages (including your own salary). That limit fully kicks in another $75,000 up the income scale if you're single, or $150,000 if you're married. In that band, paying yourself too little salary can actually shrink your QBI deduction.

But it cuts both ways — the salary you pay yourself also reduces the income that qualifies for the deduction, and it raises your payroll tax. So it's a real balancing act, not a simple "more salary is better." And below those income thresholds, this limit doesn't apply at all: your salary has no effect on the QBI deduction, so there's no QBI reason to pay yourself more.

There's a big exception, though. If you're in a professional-services field — law, medicine, accounting, consulting, financial services, and similar "specified service" trades — the QBI math works differently. Once your income climbs past that same phase-out band ($276,750 single or $553,500 married for 2026), the QBI deduction for that business disappears entirely, no matter how you set your salary. For those owners there's no salary sweet spot to find on the QBI side — so if this is you, the salary decision goes back to being mostly about payroll tax, and the QBI piece is one to model with us rather than guess at. (One footnote: this applies to your business income — if you also hold REIT or publicly traded partnership investments, the 20% deduction on those survives regardless of your income or field. And the IRS is still writing its detailed rules for the new law, so we'll flag any changes.)

The takeaway: if you're under those income levels, keep your salary reasonable — you don't need to inflate it for QBI. If you're above them and not in a service field, there's a genuine sweet spot, and it's worth having us model it before you lock in a number.

Don't forget the Indiana side

Everything above is about federal payroll taxes. Indiana works differently, and it matters. The state income tax (2.95% in 2026) and your county tax — for example, 1.10% in Hamilton County, or about 2.02% in Marion County — apply to your salary and your distributions at the same rate. So unlike the federal side, shifting dollars from salary to distribution doesn't shave a penny off your Indiana bill. (That's the picture for Indiana residents. If you live in another state but own an Indiana S corp, wages and business profits get sourced under different rules — that one needs individual modeling, not a blog post.)

There's a separate Indiana move worth asking us about — the pass-through entity tax election, which lets your S corp pay the state tax at the business level and work around the federal cap on deducting state taxes. It does connect to the salary decision in one small way: the election covers your pass-through profit, not your W-2 wages, so a lower salary slightly enlarges the slice it can reach. At Indiana's rates the effect is modest — but it's one more reason the two decisions belong in the same conversation.

The mistakes that get the salary thrown out

Four of these are the ones that actually trigger a reclassification. Skip them at your peril.

1. Zero salary (or a token one) while taking distributions. This is the single biggest red flag, and the IRS now uses data matching to find it automatically.

2. A round number with nothing behind it. If you can't point to where the figure came from, it won't hold. Have the data on file before you need it.

3. Never updating it. A salary that was reasonable three years ago may not be reasonable now if your business has grown. Revisit it every year.

4. A single year-end lump sum instead of real payroll. Reasonable compensation should look like a paycheck — run on a regular schedule, with the payroll taxes deposited on time.

5. No paper trail. One page a year does it: the method you used, the data you relied on, and a short note in your records approving the salary.

6. (Loss years count too.) If you're working in the business and pulling cash out, that cash can be recharacterized as wages — even in a year the business lost money. What triggers the rule is paying yourself for work, not whether the business turned a profit.

Who this matters to

This applies to you if you own an S corp (or a multi-member LLC taxed as one) and you do real work in the business. If your profit is consistently under about $40,000–$50,000, it's also worth asking whether the S-corp election is still earning its keep — we walked through that math in our post on S-Corp vs. Sole Proprietor.

The bottom line

Your reasonable salary isn't a number you pull from thin air, and it isn't the lowest number you can imagine. It's a reasonable, well-supported number — backed by what people in your role actually earn, written down once a year, and paid out like a real paycheck.

Get it right and you keep thousands in payroll tax that a sole proprietor never could. Get it wrong and you hand it all back with penalties on top.

That's exactly the kind of thing we set up for clients. If you're not sure your salary would hold up — or you've been taking distributions without one — let's figure out your number before the IRS decides to figure it out for you.

This article is for general information and isn't tax advice for your specific situation. Schaaf CPA Group can help you evaluate whether this strategy fits your circumstances.