Reasonable Salary (S-Corp)

If you've elected S-Corp status for your freelance business, the IRS requires you to pay yourself a "reasonable salary" before taking any profit distributions. This is the trade-off for the payroll tax savings that S-Corps offer — you can't just pay yourself $10,000 in salary and take $140,000 in distributions to avoid payroll taxes.

But what counts as "reasonable"? The IRS doesn't give a specific formula. Instead, they look at several factors: what similar businesses pay for similar roles, your training and experience, the time you devote to the business, your company's revenue and profit, comparable wages in your geographic area, and whether you'd be willing to pay someone else that amount to do your job.

The general rule of thumb used by many CPAs is that reasonable salary typically falls between 40% and 60% of your S-Corp's net income, but this varies significantly by industry, income level, and how hands-on you are. A freelance consultant who does all the client work, sales, and admin should set a higher salary percentage than an S-Corp owner who has subcontractors doing most of the work. The IRS has successfully challenged S-Corp owners who set their salaries too low, resulting in reclassification of distributions as wages plus penalties and back taxes.

Getting your reasonable salary right is the linchpin of the entire S-Corp tax strategy. Set it too low and you're inviting an IRS audit that could cost you more than you saved. Set it too high and you're negating the tax benefit of the S-Corp election. Most CPAs recommend documenting how you arrived at your salary — pull comparable salary data from the Bureau of Labor Statistics, Glassdoor, or industry surveys, and keep that documentation in your tax file. If the IRS ever asks, you want a clear, defensible answer.