In an S corporation, profits that flow to owners as distributions aren't subject to Social Security and Medicare taxes. Wages are. That's the appeal, and also the reason the IRS requires owners who work in the business to pay themselves reasonable compensation before taking distributions.
Where the savings come from
Employment taxes total 15.3% on wages up to the Social Security wage base, which is $184,500 in 2026, and 2.9% above it, plus a 0.9% additional Medicare tax for high earners. Every dollar shifted from salary to distribution avoids those taxes. For a practice owner, the savings can be meaningful, but the salary still has to be supportable.
What makes a salary reasonable
There is no fixed formula. The IRS and courts look at what you'd have to pay someone else to do your job, considering:
- Your training, experience and the hours you work.
- Your duties and responsibilities in the business.
- What comparable businesses pay for similar services.
- The company's gross receipts, profits and distribution history.
- How much of the revenue comes from your personal services versus staff, equipment or capital.
For a physician or dentist who produces most of the revenue personally, a reasonable salary is usually a substantial share of profit. For a business where much of the profit comes from employees or invested capital, it can be a smaller share.
Salary drives retirement contributions
401(k) profit sharing and cash balance plan contributions for S corporation owners are based on W-2 wages, not distributions. A salary that's too low can cap how much you can put away. Many owners find the best salary is the one that balances payroll tax savings against the deductible retirement contributions they want.
The QBI deduction interaction
The 20% qualified business income deduction, made permanent by the 2025 tax law, is calculated on profit after salary. A higher salary reduces QBI. For higher-income owners of non-service businesses, though, the deduction can be limited to a percentage of W-2 wages paid, so a higher salary can sometimes increase it. Medical, dental, legal and consulting practices are specified service businesses, where the deduction phases out entirely at higher incomes.
Other details owners miss
- Health insurance premiums paid for a more-than-2% shareholder must be included in W-2 wages to be deductible.
- Salary must actually run through payroll with withholding, not be booked at year-end as a journal entry.
- California S corporations also pay a 1.5% franchise tax on net income, which affects the comparison with other entity types.
- State pass-through entity tax elections interact with salary, distributions and estimated payments.
Document your number
Keep a short file showing how the salary was set: compensation data for similar roles, your duties and hours, and how the number was reviewed as the business changed. If the IRS ever asks, documentation made at the time is far more convincing than a reconstruction.
The bottom line
Reasonable salary is a balancing act between payroll tax, retirement goals, the QBI deduction and audit risk. We review it with our S corporation clients each fall, before year-end payroll, so the number fits both the rules and the plan.
This article is general information, not tax, legal or investment advice for your situation. Rules and thresholds change, so please talk with a qualified advisor before acting.
