S-Corp paying myself $40k salary but taking $150k in distributions - audit risk?

I run an IT consulting business as an S-corp. My accountant set me up with a $40k salary and I'm taking about $150k in distributions this year. Total revenue is around $190k.

I just read an article about the IRS cracking down on S-corps with low reasonable compensation. Am I setting myself up for an audit? My accountant says it's fine but now I'm worried.

For context: I'm the only employee, I do all the work, and I live in Texas. What's actually considered "reasonable" here?

Yeah, that ratio seems really aggressive. The whole point of the IRS reasonable compensation requirement is to prevent exactly what you're doing - minimizing payroll taxes.

I've heard the rule of thumb is at least 60/40 salary to distributions, so you're way off. You're basically paying yourself 21% salary and taking 79% as distributions.

Tax attorney here. This is a legitimate concern, and frankly your accountant's advice worries me.

The legal standard: IRC Section 162 requires that S-corp officer-employees receive "reasonable compensation" for services performed. The IRS doesn't give a specific formula, but they look at several factors:

• What similar businesses pay for comparable services
• Your qualifications and experience
• Time and effort devoted to the business
• Dividend history and overall compensation structure
• Prevailing economic conditions

The problem with your situation: You're the sole service provider generating $190k. If you hired someone to do your exact job, would they work for $40k? Almost certainly not in IT consulting.

In IRS audits like David E. Watson P.C. v. United States and Sean McAlary Ltd. v. Commissioner, the IRS successfully reclassified distributions as wages when the ratio was unreasonable.

Okay so what should I actually be paying myself? My accountant said $40k was fine because that's what the "market rate" is for someone with my experience in my area. But I do everything - sales, delivery, client management, invoicing, all of it.

If I increase my salary now, will that look suspicious to the IRS for this year?

A few things to consider:

Reasonable salary range: For an IT consultant generating $190k as the sole producer, I'd expect to see salary in the $80k-$120k range at minimum. You could use sources like:

• Bureau of Labor Statistics salary data for your occupation
• RCReports (Risk Management Association) compensation studies
• Industry-specific salary surveys

Adjusting mid-year: Yes, you can and should increase your salary now. The IRS allows reasonable adjustments. It's better to correct it proactively than wait for an audit. Document your reasoning for the increase.

The consequences of getting this wrong: If audited and deemed unreasonable, the IRS will:

1. Reclassify distributions as wages
2. Assess back payroll taxes (15.3% employer + employee FICA)
3. Add penalties and interest
4. You lose the tax benefit you thought you were getting

I run a similar business - solo consulting S-corp. My CPA has me at about 55% W-2 and 45% distributions. She said that's conservative but defensible.

The way she explained it: imagine you got hit by a bus tomorrow and had to hire someone to do your job. What would you have to pay them? That's your floor for reasonable comp.

I was trying to do something similar to you (lower salary) and she basically said "Do you want to save $5k in taxes now or risk a $30k tax bill plus penalties in an audit?"

What about the 60/40 rule people talk about? Is that actually from the IRS or just a myth?

The 60/40 "rule" is not from the IRS - it's a rule of thumb some accountants use, but it has no legal basis. The IRS has never published a safe harbor percentage.

What matters is the actual facts and circumstances test. I've seen defensible cases with 50/50 splits and cases with 70/30 that got challenged. It depends entirely on your industry, role, and market rates.

The IRS published a fact sheet (FS-2008-25) that lists the factors they consider, but they deliberately don't give percentages because every situation is different.

CPA chiming in here. I'd fire your accountant honestly.

$40k for an IT consultant generating $190k is going to be a red flag if the IRS ever looks at your return. The average IT consultant salary in most markets is $80k-$100k minimum.

Here's what I tell my S-corp clients: use the BLS data for your occupation code, adjust for your geographic area, and aim for at least the 50th percentile. Then document why you chose that amount.

Also - make sure your accountant is documenting the compensation determination in your corporate records. If audited, you want to show you made a good faith reasonable effort to comply.

Thanks everyone. This is really helpful and honestly pretty alarming. I'm going to find a new CPA who specializes in S-corps.

Based on the BLS data for my area and role, I'm going to bump my salary to $95k for the rest of the year and adjust my quarterly estimates. Better to pay the extra payroll tax now than deal with an audit later.

Smart move. And make sure your new CPA documents the compensation methodology in your corporate minutes. That contemporaneous documentation is your best defense if ever questioned.

Also consider looking at reasonable compensation studies or getting a formal compensation report if your revenue continues growing. For S-corps with significant income, it can be worth the $2k-$5k cost for the defensibility.