Why it matters
An S-corp owner who takes distributions without first paying themselves a reasonable W-2 salary is effectively avoiding payroll taxes (Social Security and Medicare) on what is really compensation for services. The IRS has won numerous cases reclassifying distributions as wages, with back FICA, FUTA, withholding, interest, and penalties.
Factors
No bright-line test. Factors include: duties performed, time devoted to the business, comparable salaries for similar services in similar geographies, training and experience, what an arm's-length employer would pay, dividend history, payments to non-shareholder employees, and the use of a formula based on revenue or profit.
Sources of comparables
The Bureau of Labor Statistics, RC Reports (a third-party service), industry compensation surveys, and similar resources provide ranges. Documenting the methodology each year — even if simple — is your best defense in audit.
Common patterns
Many S-corps target a 60/40 split: 60% of distributable cash as W-2 wages, 40% as distributions. Others use a "60% of profit" rule of thumb. The right ratio depends on industry, services rendered, and the level of profit; high-profit businesses generally have larger absolute salaries but smaller percentage allocations to wages.
Documentation
Maintain a contemporaneous file each year showing the salary set, the analysis, the sources consulted, and any changes from prior year. The file is rarely reviewed, but its existence often deters IRS challenge during a payroll audit.
How experienced filers approach this
Experienced self-employed filers and the CPAs who advise them treat this question as a recurring planning exercise rather than a one-time decision. They model the multi-year tax impact rather than just the current year, document the reasoning in a short workpaper that survives staff turnover and software changes, and revisit the analysis annually as facts and laws change. The discipline is not difficult — a half-day in January with last year's return, the current-year IRS publications, and a spreadsheet — but it is rare among DIY filers, which is precisely why it produces outsized results.