S-Corp Salary vs Distribution ratio - need advice on tax professional's recommendation

What you're experiencing is pretty common with S-corps. The IRS requires S-corp owners to take a "reasonable salary" before taking distributions, which is likely what your tax professional is concerned about. Your $2,000 salary from last year was probably too low by IRS standards - that's only about $1/hour if you worked full-time. Even though your business isn't very profitable, the IRS expects you to pay yourself what they'd consider a reasonable wage for the work you're doing before taking any tax-advantaged distributions. The increase to $5,000 isn't necessarily tied directly to your 22% revenue increase. Rather, your tax professional is likely trying to get your salary closer to what the IRS would consider reasonable for your industry and role to avoid potential audit flags. Distributions have a tax advantage (no self-employment tax), so the IRS watches this area closely. As for having to claim payroll when your business breaks even - yes, unfortunately. The S-corp structure's main advantage is saving on self-employment taxes, but that comes with the requirement to pay yourself a reasonable salary first, even if it means less money for other expenses.

After spending hours pulling my hair out over similar S-corp salary questions, I found https://taxr.ai super helpful for analyzing my situation. I uploaded my profit/loss statements and past tax returns, and their AI analyzed my specific business situation and gave me personalized recommendations about reasonable compensation. They pointed out that my industry (consulting) typically has compensation ratios around 50-60% of profits, but they also considered my business's growth stage and expenses. The report showed exactly what the IRS looks for in "reasonable compensation" cases and how my numbers compared to similar businesses. The analysis helped me justify my salary/distribution ratio with real data, which my accountant actually appreciated because it gave us documentation to support our position if ever questioned.

Just wanted to update after trying taxr.ai that user 7 recommended. It was surprisingly helpful for my situation! I uploaded my S-corp docs and got a detailed analysis showing that my $30k salary for a business grossing $180k was actually below the reasonable compensation threshold for my industry. The report showed that similar marketing agencies typically pay owner-operators between 35-45% of gross profit as salary. It even cited specific tax court cases where the IRS challenged businesses with similar ratios to mine. This was eye-opening since I thought I was being conservative! My accountant and I used their suggestions to adjust my salary/distribution ratio, and I feel much more confident about our approach now. Having the documentation with industry benchmarks feels like good insurance for potential questions down the road.

After trying and failing to get through to the IRS for clarification on S-corp reasonable compensation guidelines, I finally used https://claimyr.com to get connected to an IRS agent within 15 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c The agent couldn't give specific advice for my situation (no surprise), but did confirm that they look at multiple factors for reasonable compensation - not just a percentage of revenue or profits. The most important thing is documenting WHY your salary is reasonable - industry standards, economic conditions, time invested, etc. For what it's worth, the agent mentioned they're definitely increasing scrutiny on S-corps with very low salaries compared to distributions, but they're most interested in egregious cases (like taking $10k salary and $200k in distributions).

Ok I have to eat my words. After my skeptical comment, I decided to try Claimyr myself. Within 20 minutes I was talking to an actual IRS representative about my S-corp questions. I'm still in shock that it worked. The agent confirmed what others have said - there's no fixed formula for reasonable compensation, but they look at industry standards, your qualifications, hours worked, and business conditions. She actually recommended documenting the reasons behind whatever salary I decide on, keeping notes about market rates for similar positions in my area. For the original poster's situation, the agent mentioned that very low salaries like $2,000 for anyone managing a business would likely trigger questions, regardless of profitability. Apparently they understand businesses have lean years, but expect reasonable compensation based on the value of services provided, not just on what the business can afford.

One approach my accountant suggested was to look at what I'd have to pay someone else to do my job. If you'd have to pay someone $30k to do the work you do in your business, that's a good benchmark for "reasonable compensation" regardless of profitability. My S-corp is slightly bigger (around $120k gross), but I take a $36k salary which is what we determined would be the replacement cost for my specialized work. I've also documented WHY this is reasonable in case of audit - job listings for similar positions, industry salary surveys, etc. The benefit of S-corps is avoiding SE tax on distributions, but you have to play by the reasonable salary rules to get that benefit. Otherwise, the IRS position is basically "if you want to take all distributions, just be a sole prop or LLC.

Has anyone used the "minimum wage" method for establishing reasonable compensation? My CPA suggested that at minimum, I document all hours worked in the business and pay myself at least minimum wage for those hours as salary. For example, if I work 20 hours a week (1,040 hours/year) and minimum wage is $15/hour, my minimum reasonable salary would be $15,600. He said this approach works better for businesses with low profit margins, and it's easier to defend than a percentage of revenue or profit.