When one is employed at a company that they do not own, they generally want the largest salary they can possibly get. But as a small business owner, the same is not necessarily true when you are an employee of an S Corporation that you yourself own.

This is because every dollar in employment income that you are paid has an additional tax for Social Security and Medicare (FICA). The combined rate is 15.3% — 12.4% for Social Security and 2.9% for Medicare (IRS, Self-Employment Tax). The Social Security part stops at an annual wage cap; the Medicare part does not. Current cap and prior years are in the section near the end of this article.

To make matters worse, as both the employee and employer you have to pay “both sides” of this tax, whereas an employee of someone else’s company would pay only one side.

But as an owner of an S Corporation, you can take part of your profit as a non-wage distribution. The IRS treats non-wage distributions as not subject to employment taxes (Social Security and Medicare) — see the IRS page S Corporation Compensation and Medical Insurance Issues. (These distributions are not capital gains; they are your share of the company’s ordinary profit, paid out without payroll tax.)

This ability to pass through profit as non-employment income and forego the additional FICA taxes makes an S-Corp Tax Election a great opportunity to save substantial money on taxes.

Why paying yourself a salary is necessary

So you might be thinking to yourself if you have to pay extra taxes on salaried income, but not on distributions, you should just pay yourself the smallest salary possible. Or better yet, no salary at all!

Well, not so fast…

The IRS does not allow us to completely forego our FICA taxes. “It’s for your own good” they would say. Because, in theory, you are investing in your retirement.

That being the case, they require you to pay yourself a “reasonable” salary.

Failure to do so could lead to you being flagged for an audit. And such an audit could ultimately lead to you having to pay back all of the FICA taxes that they would determine should have been paid, plus penalties and interest.

And that could be devastating for a small business owner.

Choosing the right salary

The idea behind reasonable salary is that if you were to hire someone else to step in and do your job, or if you were to go to work for another company in the same position, what would the fair market salary of that position be?

To determine this, there is no set formula. The IRS lists these factors in determining reasonable compensation (IRS, S Corporation Compensation and Medical Insurance Issues):

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of a formula to determine compensation

The same IRS page gives the underlying test: look at where the company’s gross receipts come from. Receipts generated by your own personal services point to wages; receipts generated by other employees or by capital and equipment can support non-wage distributions. For a contractor who is on the tools and running the crews, a large share of receipts traces back to the owner’s services — which is why a token salary is hard to defend.

Well, if that all seems very arbitrary to you, you are not alone.

Another way to go about this is by going to bls.gov or salary.com and entering your job title and location.

Additionally, you could go to actual job postings on sites like monster.com and indeed.com and see what compensation other companies similar to yours are offering for similar roles.

While this is not a perfect solution since, as mentioned above, the IRS takes many factors into consideration, it’s a good starting place and is far better than throwing darts at the wall.

Making the final determination

Now that you’ve got your analysis out of the way, you should have a range of salaries to work with.

So the question then becomes should you go with the lower-, middle-, or upper-end of that range?

Well, as you can probably imagine, there is a fine line between maximum tax savings and flagging yourself for an audit which will end up costing you more down the road.

So if you’re not working with a tax professional who is familiar with your industry, then you usually best practice to play it safe and go with the middle, to upper-middle of the range.

Because again, going too aggressive and getting audited can end up costing you way more than any amount of taxes you would have paid in the first place because penalties and interest can be devastating.

The Social Security wage cap: current year and prior years

The 12.4% Social Security part of the 15.3% applies to combined wages and self-employment earnings only up to an annual cap. The 2.9% Medicare part applies to all of it. Figures below are from the IRS Form 1040-ES instructions for each year.

2026: the cap is $184,500 (IRS, Form 1040-ES (2026), “Social security tax”).

An additional 0.9% Medicare tax applies to wages and self-employment income above $200,000 (single or head of household), $250,000 (married filing jointly) or $125,000 (married filing separately) (IRS, Self-Employment Tax).

Filing a prior year?

The Bottom Line

As a small business owner, choosing to be taxed as an S Corporation is a great way to reduce your taxes, but you have to be strategic about choosing the right salary compensation.

Paying yourself too much is throwing away money in taxes but not paying enough opens you up to the risk of audit.

Going at this alone can be done, but it is unlikely to result in a strategic salary compensation that meets that perfect balance between too much and too little.

That’s why we recommend that you work with a competent professional who is familiar with your industry to conduct a more thorough analysis and choose the salary that strikes the perfect balance between tax savings and audit risk.

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post.