S Corporation Reasonable Salary: Fix It Before Year-End

The last payroll of the year is the last easy chance to fix an S corporation owner's salary for 2026. After December 31, wages that were not paid cannot be added back with a simple adjustment, and distributions already taken may look like disguised wages. This Briefing covers what the IRS expects, how to test your number, and the year-end items that are easy to miss, including health insurance and the California angle.

What the IRS Requires

The IRS states on its S corporation compensation page that S corporations must pay reasonable compensation to a shareholder-employee for services provided to the corporation before non-wage distributions may be made to that shareholder. The Form 1120-S instructions say distributions and other payments to a corporate officer must be treated as wages to the extent they are reasonable compensation for services.

The IRS can reclassify distributions as wages subject to employment taxes, and courts have supported that authority. The IRS page cites cases including Joly v. Commissioner, Veterinary Surgical Consultants, P.C. v. Commissioner and David E. Watson, PC v. U.S.

Start With the Source of Gross Receipts

The IRS describes the key to reasonable compensation as identifying what the owner did for the business by looking at where its gross receipts come from:

• The shareholder's own services. Receipts generated by the owner's work point toward wages.
• Services of non-shareholder employees. Receipts generated by staff can support distributions.
• Capital and equipment. Receipts produced by the company's assets can also support distributions.

The IRS adds that administrative and management work supporting other income-producing employees or assets should also be treated as wages. An owner who manages a team still earns a salary for that management.

The Factors the IRS Lists

The IRS lists these factors in determining reasonable compensation:

• 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

A defensible salary is one you can explain with these factors. A written file showing comparable pay data for your role, hours, and responsibilities is far more persuasive than a round number chosen to minimize payroll tax.

Red Flags to Fix Before the Last Payroll

• No salary at all while the owner works full-time and takes distributions.
• A salary that has not changed in years while profits and the owner's role have grown.
• Distributions far larger than wages in a business that depends mainly on the owner's own services.
• A salary below what you pay employees who report to you.
• Wages paid only in December with no regular payroll during the year. A year-end bonus is acceptable, but it should be run through payroll with withholding.

If you need to increase wages, a year-end bonus processed through payroll before December 31 is usually the cleanest fix. It must go through payroll with income tax withholding and Social Security and Medicare taxes, not as a transfer from the business account.

Health Insurance for 2-Percent Shareholders

Health insurance is one of the most common year-end errors. The IRS explains that premiums paid by the S corporation for a more-than-2-percent shareholder-employee are deductible by the corporation and reportable as wages in Box 1 of the shareholder's Form W-2. When the premiums are paid under a plan for employees, the amount is not subject to Social Security, Medicare, or FUTA tax, so it is not included in Boxes 3 and 5.

To claim the above-the-line self-employed health insurance deduction on the Individual tax return, the premiums must ultimately be paid by the S corporation and reported as wages on the shareholder's W-2. If you paid premiums yourself, reimburse them through the company and add them to your W-2 before the year-end payroll is closed. The IRS also notes that 2-percent shareholders cannot participate in a QSEHRA or a health flexible spending arrangement.

How Salary Interacts With QBI

Reasonable compensation is not qualified business income, but it does count toward the W-2 wage limit for owners above the 2026 thresholds of $201,750 ($403,500 joint) under Rev. Proc. 2025-32. That trade-off can make a higher salary cost less than it seems, or more. See QBI Is Permanent in 2026: How S Corporation Wages Affect the Deduction. Compensation must be reasonable first; tax optimization comes second.

The California Angle

California follows the federal treatment of S corporation wages and distributions for income tax purposes, but two state rules make salary decisions more important:

• PTET. If your S corporation elects the 9.3% pass-through entity elective tax, the tax is computed on the shareholders' pro rata share of income. Wages reduce that share, which reduces both the PTET and the credit. Change salary and PTET estimates together.
• California payroll taxes. Owner wages are also subject to California payroll withholding and reporting, so a December bonus needs to be processed through your California payroll account, not added after the fact.

For other year-end items, see our 2026 year-end checklist. For background, our earlier Briefings cover the benefits of S corporations and assignment of income issues.

Key Takeaways

• An S corporation must pay reasonable compensation to a shareholder-employee before taking non-wage distributions.
• Base the salary on the source of gross receipts and the IRS factors, and document comparable pay.
• Fix shortfalls with a bonus through payroll before December 31, with full withholding.
• Report health insurance premiums for 2-percent shareholders as W-2 wages to preserve the deduction.
• Coordinate salary with the QBI wage limit and California PTET.

If you want your 2026 owner salary reviewed before the final payroll, schedule a consultation with SMB CPA Group. You can also contact us, learn about our custom scope of work, or review our pricing.

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