S-Corporation owners are required to pay themselves a reasonable salary through payroll before taking any additional profit as distributions. The reason this rule exists is straightforward: distributions aren't subject to self-employment tax the way salary is, so without a reasonable-salary requirement, an owner could take their entire income as distributions and avoid payroll taxes almost entirely.
Why "reasonable" is deliberately not a fixed number
There's no single formula the IRS applies uniformly — reasonable compensation is generally assessed against what a similar business would pay an unrelated employee to perform the same role, considering factors like industry, business size, and the owner's actual duties. That ambiguity is exactly what makes this an easy area to get wrong without meaning to.
Where the actual audit risk comes from
An S-Corp owner who takes a token salary — far below what the role would reasonably cost to fill with an outside hire — while taking the bulk of income as distributions is a well-documented audit pattern. The IRS has pursued reclassification of distributions as wages in exactly this scenario, which comes with back payroll taxes and penalties, not just the tax that would have been owed originally.
Why this needs to be checked against cash flow, not just tax risk
Setting salary too high relative to what the business can actually support strains cash flow, particularly in a business's early years. The practical exercise isn't just estimating a defensible reasonable-compensation number — it's checking that number against a safe monthly draw the business can actually sustain, so the fix for audit risk doesn't create a cash flow problem in its place.