Reasonable Compensation Studies Explained: Why They Matter for S-Corp Owners

When you own an S-Corporation, one of the most important IRS rules to follow is paying yourself a reasonable salary. The IRS watches this closely, and failing to comply can lead to audits, penalties, and back taxes. On the other hand, paying yourself the right amount — and documenting how you arrived at it — can unlock major tax savings. That’s why a reasonable compensation study is essential for S-Corp owners.

What Is “Reasonable Compensation” for an S-Corp?

The IRS requires shareholder-employees of S-Corporations to take a salary that reflects the fair market value of the work they perform.

In plain terms:

• Your paycheck should be similar to what someone else in your role, with comparable experience, would earn in your industry and location.
• Any income beyond that salary may be taken as a distribution, which is not subject to payroll taxes.

This balance between salary and distributions is one of the main tax advantages of an S-Corp — but only if handled properly.

Why a Reasonable Compensation Study Matters

• IRS Audit Protection: A documented study shows the IRS you followed a defensible process when setting your salary.
• Tax Optimization: Paying too little risks penalties, while paying too much increases payroll taxes. The right balance saves you money.
• Confidence & Compliance: With a study in hand, you can focus on your business knowing your compensation strategy is on solid ground.

How a Compensation Study Works

A reasonable compensation study uses data and analysis to back up your salary decision. Steps usually include:

1. Job Analysis – Review the tasks you perform (clinical work, administration, management, business development, etc.).
2. Market Comparisons – Pull industry-specific salary data adjusted for your geographic area.
3. Time Allocation – Weight salary across the various roles you perform.
4. Final Report – Documented evidence that supports your salary figure in case of IRS scrutiny.

Common Mistakes S-Corp Owners Make

• Taking no salary and only distributions.
• Guessing a flat salary without market research.
• Not updating salary as the business grows or their role changes.

Frequently Asked Questions About Reasonable Compensation

What happens if an S-Corp owner doesn’t take a reasonable salary?
If you don’t pay yourself a reasonable salary, the IRS may reclassify some (or all) of your distributions as wages. This can lead to back payroll taxes, penalties, and interest. A compensation study helps protect against this risk.

How does the IRS decide what’s “reasonable” compensation?
The IRS looks at factors like your role, duties, training, experience, industry norms, and location. Essentially, it asks: What would you pay someone else to do the same job?

Can I pay myself a low salary to save on taxes?
No — setting your salary artificially low is one of the biggest red flags for an IRS audit. While it may save payroll taxes in the short term, it exposes you to compliance risks and potentially steep penalties.

Do I need a reasonable compensation study every year?
Not always, but it’s a good practice to revisit your salary regularly, especially if your business grows, your role changes, or you expand into new states. Documenting updates shows you’re staying compliant.

Who should perform a reasonable compensation study?
A CPA who understands S-Corp taxation (and your industry) is the best person to prepare this study. They can analyze your role, benchmark salaries, and provide a defensible report if the IRS ever asks questions.

Final Thoughts

A reasonable compensation study isn’t just about compliance — it’s about protecting your business and maximizing your tax benefits. By documenting your salary the right way, you avoid red flags with the IRS and keep more of what you earn.

At Pulse CPA, we help S-Corp owners — especially independent contractor healthcare providers — establish compensation strategies that are IRS-compliant and tax-efficient. If you haven’t reviewed your salary recently, now is the time to do it.