Founder of GTA Accounting Group, Sohail helps businesses grow with expert tax strategies and financial planning.
There is no IRS percentage and no safe harbour. This guide covers the gross-receipts test the IRS actually applies, the nine factors it weighs, the four cases it cites, and how New York, New Jersey and California change what the split is worth.
If you are a shareholder-employee who provides services to an S corporation, the IRS generally requires you to receive reasonable compensation before receiving non-wage distributions. The hard part is the number. There is no IRS formula, no approved percentage, and no threshold that makes a salary automatically safe. What exists instead is a test, nine factors, and a set of court decisions the IRS cites. This guide covers all three, then explains how New York, New Jersey and California change what that decision is worth, which is the part most national guides leave out.
The rule is short. The IRS states that S corporations "must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee."
Two things follow from that sentence, and both are commonly missed.
The first is sequence. Reasonable compensation comes before distributions, not alongside them. An owner who takes money out all year and works out the salary at year end has the order backwards.
The second is that the requirement is tied to services. It applies to a shareholder-employee who provides services to the corporation, and what is reasonable is measured against those services. That is why the rest of this guide is about the work you do, not about the profit the company made.
The instructions to Form 1120-S make the same point from the other direction: "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."
| Situation | Treatment |
|---|---|
| Owner performs substantial services for the company | Wage territory, payroll required |
| Owner performs no services, or only minor services, and receives no pay | Not an employee for this purpose |
| Receipts generated by employees or by equipment | Supports distribution treatment |
Source: IRS, S Corporation Compensation and Medical Insurance Issues.
This article is about what the owner should be paid. If your question is whether an S corporation should be issued a 1099, that is a separate rule, covered in our guide on whether S corps receive 1099 forms.
Most owners arrive at this question having heard a percentage. Pay yourself 60% of profit as salary and take 40% as distributions. Or 50/50. Or a third.
None of these come from the IRS. We searched the IRS's published guidance on S corporation compensation and on paying yourself. Neither contains a percentage, a ratio, or the phrase "safe harbor" anywhere. The rules of thumb circulating online are conventions that firms invented, and they carry no authority.
They also fail on their own terms, because they answer the wrong question. A percentage of profit assumes profit drives the salary. It does not. Two businesses can post identical profit and justify very different owner salaries, because the salary depends on the work the owner personally did, not on how much the company made.
That is not a technicality. It is the whole basis of the test the IRS actually applies.
This is the part worth reading twice, because it is the method, and almost no other guide covers it.
The IRS instruction is to establish "what the shareholder-employee did for the S corporation by looking to the source of the S corporation's gross receipts." It identifies three sources:
Treatment follows the source. Where receipts come from employees, or from capital and equipment, "payments to the shareholder would properly be treated as non-wage distributions that are not subject to employment taxes." Where receipts come from the shareholder's personal services, "payments to the shareholder-employee should be classified as wages."
There is an extension that catches people out. Supervision counts. As the IRS puts it, "a manager may not directly produce gross receipts, but he assists the other employees or assets which are producing the day-to-day gross receipts." An owner who has stopped doing the billable work but still runs the people doing it has not left wage territory.
Two owners, same industry, same annual profit. Assume both work full time in the business and both take money out.
The first is a sole practitioner. Every engagement is delivered personally. There are no employees and no significant equipment. Almost all gross receipts trace to her own services, so almost everything she takes out sits in wage territory. A low salary here is difficult to defend.
The second owns a firm with five staff who deliver most of the work. He sells, supervises and signs off. A meaningful share of receipts traces to his employees rather than to him, so a larger share of what he takes can reasonably be distribution. His supervision still counts as services, so it does not fall to zero.
Same profit. Different defensible answers. That is what the framework does and a percentage cannot.
A distinction worth holding onto: the shares above describe where revenue came from. They are not a percentage of profit to pay as salary. Splitting receipts by source is the IRS's analysis. Splitting profit by a fixed ratio is the myth from the previous section. They are easy to confuse and only one of them is grounded.
Alongside the receipts test, the IRS publishes a list of factors relevant to determining reasonable compensation. The list is reproduced here in full.
| Factor | What it means in practice |
|---|---|
| Training and experience | A specialist commands more than a generalist |
| Duties and responsibilities | What the role actually involves day to day |
| Time and effort devoted to the business | Full time and part time are not the same case |
| Dividend history | A pattern of large distributions with small wages invites scrutiny |
| Payments to non-shareholder employees | What you pay staff is evidence about what the work is worth |
| Timing and manner of paying bonuses to key people | Year-end lump sums look different from regular payroll |
| What comparable businesses pay for similar services | A comparison point drawn from outside your own business |
| Compensation agreements | A written arrangement set in advance carries weight |
| The use of a formula to determine compensation | A consistent, documented method beats an ad hoc number |
The IRS does not rank these factors, and neither should you. One is worth drawing out only because it is easy to overlook: payments to non-shareholder employees. If you pay a manager more than you pay yourself for comparable responsibility, that comparison sits in your own payroll records.
The IRS cites four decisions supporting its authority in this area.
| Case | Citation | Cited by the IRS for |
|---|---|---|
| Joly v. Commissioner | T.C. Memo. 1998-361, aff'd by unpublished opinion, 211 F.3d 1269 (6th Cir. 2000) | Authority to reclassify |
| Veterinary Surgical Consultants, P.C. v. Commissioner | 117 T.C. 141 (2001) | Employment status of shareholders |
| Joseph M. Grey Public Accountant, P.C. v. Commissioner | 119 T.C. 121 (2002) | Employment status of shareholders |
| David E. Watson, PC v. U.S. | 668 F.3d 1008 (8th Cir. 2012) | Reasonable reimbursement for services performed |
What that table establishes is deliberately narrow. The IRS states that it has authority to reclassify payments made to shareholders from non-wage distributions to wages, and it points to these decisions as supporting that authority and as addressing the employment status of shareholders. Nothing further is asserted here about what any of them decided.
Setting a defensible salary is half the work. Being able to show how you set it is the other half, and it is the half most owners skip.
Build the file when you set the number, not after a question arrives. It should contain:
Keep each year's file. A consistent, documented method applied over several years is a far stronger position than a number that appears without explanation. Documentation improves your position; it does not guarantee any particular outcome.
Owner pay runs through payroll as W-2 wages. It is not a transfer, a draw, or a 1099 payment to yourself. The IRS is explicit that you "cannot designate a worker, including yourself, as an employee or independent contractor solely by the issuance of Form W-2 or Form 1099-NEC." If the distinction is unfamiliar, our guide to 1099 and W-2 classification covers it. Setting up and running the payroll is straightforward with help; we do this for clients through our payroll services in New York, New Jersey and California.
If the IRS concludes compensation was unreasonably low, it can reclassify distributions as wages. The consequence is employment taxes on the reclassified amount, plus interest, plus any penalties that apply.
Two features make this worse than a single-year problem. A low-salary position is usually consistent, so if it is wrong in one year it is generally wrong across every open year. And the amounts compound: employment taxes on several years of reclassified distributions, with interest running from each original due date.
An adjustment of this kind normally begins as correspondence rather than a knock at the door. Our guide on what to do when an IRS notice questions your figures explains how that process works and how to respond.
Splitting your pay between salary and distribution is worth doing because of the employment tax that does not apply to the distribution side. How much that is worth depends on what your state, and in one case your city, does with the S election in the first place. Two owners can set an identical, equally defensible salary and end up with very different results, purely because of where they operate.
Almost every guide on this subject stops at the federal rules, which leaves that part out. Here is what changes in the three states this firm works in. This is a summary of the state layer, not a full guide to any of these tax systems.
New York State does not follow the federal election by default. In the state's words, if shareholders "made an S election for federal purposes, New York State does not automatically treat the company as a New York S corporation unless it is mandated to file as an S corporation under Tax Law § 660(i)."
To elect New York S treatment, file Form CT-6. The corporation must be a federal S corporation, must be taxable under Article 9-A, and must have consent from all shareholders.
There is an important exception in the other direction. A federal S corporation that has not elected New York treatment is deemed to have elected it if its investment income is more than 50% of its federal gross income for the year. Investment income here means interest, dividends, royalties, annuities, rents and gains from dealings in property, including the corporation's share of those items from a partnership, estate or trust. A corporation deemed to have elected must file Form CT-3-S.
So the accurate statement is not that New York ignores the federal election. It is that New York does not follow it automatically, and in one specific circumstance follows it whether you elected or not.
Source: New York State Department of Taxation and Finance, Article 9-A franchise tax on S corporations.
This is the biggest adjustment for an owner in the five boroughs, and it changes the arithmetic of the whole election.
New York City's guidance is unambiguous: the city "does not have an S corporation election and does not recognize a New York State S corporation election."
The city taxes S corporations at the entity level under the General Corporation Tax. For tax years beginning on or after January 1, 2015, that tax applies only to subchapter S corporations and qualified subchapter S subsidiaries; every other corporation moved to the business corporation tax. It reaches all domestic and foreign S corporations and qualified S subsidiaries in the city that are doing business, employing capital, owning or leasing property in a corporate or organized capacity, or maintaining an office.
The practical effect is that a New York City owner gets the federal benefit of pass-through treatment and still pays city tax at the entity level. The election is worth less here than a national article implies, and for some owners that changes whether it is worth making. Entity-level filing is covered on our New York corporate tax page.
Source: New York City Department of Finance, General Corporation Tax.
New Jersey removed the separate state S corporation election for federal approval letters dated on or after December 22, 2022. This is widely reported as New Jersey becoming automatic. That is not what the state says, and the distinction matters.
New Jersey's guidance is that "without exception," federal S corporations and qualified subchapter S subsidiaries must:
The Shareholder Jurisdictional Consent is the shareholders' acknowledgment that New Jersey has the right to tax each shareholder's S corporation income regardless of where that shareholder lives. Every shareholder must be listed with their ownership percentage.
There is a trap for converted businesses. An entity previously registered as something other than a corporation, such as an LLC registered as a 1065 filer, must first change its ownership type to an 1120 filer through a Business Entity Conversion or Domestication filing before it can be recognized as a New Jersey S corporation. Skip that step and the recognition does not happen.
Ongoing, any change in shareholders or stock ownership must be reported, on Schedule SJC within Form CBT-100S. A federal S corporation that does not want New Jersey S treatment can opt out through a C Corporation Tax Status Election, which requires the consent of 100% of shareholders. Entity-level filing is covered on our New Jersey corporation and partnership tax page.
Source: New Jersey Division of Taxation, P.L. 2022, c. 133 New Jersey S Corporation Procedural Changes.
California applies two things, and conflating them produces the wrong answer.
S corporations are subject to an annual $800 minimum franchise tax. Separately, California taxes every S corporation with California source income at 1.5%. The return is Form 100S, due the 15th day of the third month after the close of the taxable year.
The $800 is due in the first quarter of each accounting period and is payable "whether your corporation is active, inactive, operates at a loss, or files a return for a short period."
Newly formed or qualified S corporations have the minimum tax waived on their initial return for the first taxable year. But the Franchise Tax Board is explicit that "any first-year net income is still subject to the 1.5% tax rate." A first year is not a free year. Entity-level filing is covered on our California corporation and partnership tax page.
Source: California Franchise Tax Board, S corporations.
| New York | New Jersey | California | |
|---|---|---|---|
| Follows the federal election automatically? | No, unless mandated under § 660(i) | Election removed, but recognition still requires steps | Yes, for the state's own S corporation treatment |
| What you must do | File Form CT-6 | Register with DORES, prove federal status, file the Shareholder Jurisdictional Consent | File Form 100S |
| Entity-level cost | Franchise tax under Article 9-A | Corporation Business Tax | $800 minimum, plus 1.5% on California source income |
| Local layer | New York City taxes S corps under the General Corporation Tax and ignores S status | None equivalent | None equivalent |
None of this changes what a reasonable salary is. The federal test in the sections above is the same in all three states. What changes is what the split is worth to you once it is set, which is worth knowing before you decide the election is doing the work you think it is.
A reasonable salary is not a decision you make once. The facts that justify it change, and when they change the number should be re-examined. Common triggers:
An annual review, documented, is the simplest way to keep the position current. It also fits naturally with year-end planning, covered in our year-end tax planning guide. If your company issues Schedule K-1s, the distribution side shows up there; our guide on K-1 timing and delays covers what to expect.
1. Is a corporate officer automatically an employee?
Generally yes. The IRS states that "an officer of a corporation is generally an employee." The exception is narrow: "an officer who performs no services or only minor services and who neither receives nor is entitled to receive any pay is not considered an employee." So the exemption requires both halves, no meaningful services and no pay. Doing the work and simply not paying yourself does not reach it. The IRS points to Publication 15-A for the fuller test of who counts as an employee.
2. Can I lend myself money from the company instead of taking a salary?
Not as a substitute for compensation, and a loan that is not really a loan will not be treated as one. The IRS expects a loan to a corporate officer to have "the characteristics of a loan made at arm's length": a contract, a stated interest rate, a specified length of time for repayment, and a consequence for failure to repay. Collateral also points toward a genuine loan. Where a corporation makes a shareholder or employee a below-market loan, the IRS says the payment is treated, depending on the substance of the transaction, as "a gift, dividend, contribution to capital, payment of wages, or other payment." In other words, an informal draw called a loan can end up recharacterized as wages anyway.
3. Do my health insurance premiums count as part of my compensation?
For a shareholder-employee who owns more than 2% of the stock, yes. The IRS states that health and accident insurance premiums paid on behalf of a greater than 2-percent shareholder-employee are deductible by the corporation and "reportable as wages on the shareholder-employee's Form W-2, subject to income tax withholding." They are not subject to Social Security, Medicare or unemployment taxes where the premiums are paid under a plan covering all or a class of employees, so they appear in Box 1 of the W-2 but not in Boxes 3 and 5. A more than 2-percent shareholder-employee may also be eligible for an above-the-line deduction for those premiums, though not if the shareholder or their spouse was eligible to participate in a subsidized health plan. This is worth getting right, because it changes what your W-2 shows.
4. Are distributions the same thing as dividends?
Not quite, and the difference matters when you look at your own return. The IRS states that "any distribution to shareholders from earnings and profits is generally a dividend," but that "a distribution is not a taxable dividend if it is a return of capital to the shareholder." Distributions are usually cash, but the IRS notes they may also be made in stock or other property.
5. If the IRS adjusts my compensation, does that affect my personal return too?
It can. The IRS is explicit that where an officer is underpaid for services provided, it "may determine that adjustments must be made to the income and expenses of tax returns for both the corporation and an individual shareholder." People often assume an adjustment is a company-level problem. It is not necessarily contained there.
6. Where does the IRS suggest looking for comparable pay information?
It gives one specific pointer. Alongside the instruction that wages "should generally be commensurate with your duties," the IRS notes that "public libraries may have reference sources that provide averages of compensation paid for various types of services." That is a modest suggestion rather than an endorsed data set, but it tells you the kind of evidence the IRS has in mind: published averages for the type of work, not a number derived from your own profit.
7. We have two shareholders who do very different amounts of work. Should we take the same salary?
There is no requirement that shareholders be paid equally, and equal pay for unequal work is harder to defend, not easier. The test is applied to each shareholder-employee against the services that person provides. Two of the IRS's listed factors speak to this directly: duties and responsibilities, and time and effort devoted to the business. A shareholder who works full time in delivery and one who attends a quarterly meeting are not in the same position, and their compensation does not have to look the same. Ownership percentage drives the distribution side, not the wage side.
8. I am a partner in a partnership or a multi-member LLC, not an S-corp shareholder. Does any of this apply to me?
No, and the mechanics are different enough that borrowing them causes problems. The IRS states that "partners are not employees and should not be issued a Form W-2 in lieu of Form 1065, Schedule K-1, for distributions or guaranteed payments from the partnership." Reasonable compensation as described here is a shareholder-employee question. If your entity issues K-1s, our guide on K-1 timing and delays covers what to expect from that side.
Setting a reasonable salary is a judgment supported by evidence, and it is easier to make once with a documented method than to reconstruct later. We work with owner-managed companies across New York, New Jersey and California on exactly this, from the receipts analysis and benchmarking through to running the payroll and keeping the file current year to year. You can read more about how we support small businesses and professional services firms.
This article is general information, not tax advice for your specific situation. Confirm current figures against IRS or state guidance, or speak with a licensed professional, before acting.
Every rule stated above traces to one of the following. All were read at source in September 2026.
Figures, thresholds and procedures change. Confirm against the linked source before relying on any of them.
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