Enough to be reasonable compensation for the work you actually do for the firm, paid as W-2 wages before you take distributions. The IRS does not publish a percentage or a dollar figure; it looks at where the firm's revenue comes from and at factors such as your training, duties, hours and what comparable firms pay. The right number is one you can explain and document.
A salary set too low invites the IRS to reclassify distributions as wages; a salary set too high gives up the payroll tax savings that made the election worthwhile. Setting and documenting the number is part of Kathryn Meyer's work on tax planning for law firms.
What the IRS requires
The IRS states the rule plainly: an S corporation must pay reasonable compensation to a shareholder-employee for the services that person provides before non-wage distributions may be made. The Instructions for Form 1120-S say that distributions and other payments to a corporate officer must be treated as wages to the extent they are reasonable compensation for services, and Publication 15 adds that corporate officers who work in the business are employees of the corporation. For a lawyer who owns and runs the firm, that means payroll, withholding and a Form W-2 for the owner.
The reason the number matters is the split explained in Tax-Smart Lawyering: wages carry Social Security and Medicare tax, and distributions do not. That gap is also why the IRS watches the salary line. If you have not yet made the election, or made it late, start with whether your firm can still elect S corporation status.
How to set a reasonable salary, step by step
- List what you do. Client work, supervising associates and staff, business development, billing, and running the office. The IRS treats administrative work that supports other income-producing employees as services that call for wages too.
- Trace the firm's revenue to its sources. The IRS names three: the shareholder's own services, the work of non-shareholder employees, and capital and equipment. Revenue produced by your own services points toward wages; revenue produced by staff or equipment can support distributions.
- Price your role in the market. Ask what the firm would have to pay a lawyer with your training and experience to do your job, at your hours, in your market.
- Test the number against the firm's own history. Compare it with what you pay non-owner lawyers and staff, how bonuses have been paid, and how much has gone out as distributions.
- Write it down. A short memo or board resolution that states the salary, the method and the data behind it. A compensation agreement or a formula is one of the IRS's listed factors.
- Run it through payroll. Withhold and deposit on schedule, as explained in when a small law firm has to deposit payroll taxes.
- Revisit it each year. A practice that adds associates, changes practice areas or doubles its revenue may need a different number.
The IRS factors, applied to a law firm
The IRS's S corporation compensation page lists the factors below. None is decisive on its own, and the list is not exhaustive.
| IRS factor | What it looks like in a law firm | Evidence worth keeping |
|---|---|---|
| Training and experience | Years in practice, practice area, certifications | Resume or bar admission history |
| Duties and responsibilities | Lead counsel on matters, supervision, management | Job description, organization chart |
| Time and effort devoted to the business | Full time, part time, or splitting time with another business | Calendar or timekeeping records |
| Dividend history | How much has gone out as distributions compared with wages | Forms 1120-S, K-1s and W-2s for several years |
| Payments to non-shareholder employees | What the firm pays associates and staff | Payroll registers |
| Timing and manner of paying bonuses to key people | Year-end bonuses and how they were set | Bonus policy, payroll records |
| What comparable businesses pay for similar services | Pay for lawyers in similar roles and markets | Salary surveys or job postings, with dates |
| Compensation agreements | Employment agreement between you and the firm | Signed agreement |
| The use of a formula to determine compensation | A stated method, such as a base plus a share of fees you originate | Written formula and the yearly calculation |
What the salary costs in payroll tax in 2026
Publication 15 (2026) sets the rates below. The employee share is withheld from your paycheck and the employer share is paid by the firm, so an owner effectively bears both.
| Tax | 2026 rate | Wages it applies to |
|---|---|---|
| Social Security | 6.2% employee and 6.2% employer | Up to the $184,500 wage base |
| Medicare | 1.45% employee and 1.45% employer | All wages, no cap |
| Additional Medicare Tax | 0.9% withheld from the employee only | Wages over $200,000 in the calendar year |
| Federal unemployment (FUTA) | 6.0%, or 0.6% after the full state credit | First $7,000 of each employee's wages |
The firm's S corporation post gives the 2026 Social Security wage base as $184,500; Publication 15 and the Social Security Administration both confirm that figure.
What happens if the salary is too low
The IRS says it has the authority to reclassify payments to a shareholder from non-wage distributions to wages, and it lists court decisions that support that authority, including David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012). Reclassified amounts become wages subject to employment taxes, so the corporation can owe back payroll taxes on them, along with the penalties and interest discussed in what penalties the IRS can add after an audit. The firm's own planning page puts it simply: no salary is a red flag, and a salary that is too low is the same issue from the other side.
One limit works in the owner's favor. The IRS's page notes that reasonable compensation will never exceed what the shareholder actually received, directly or indirectly. In a year when the firm distributes little or nothing, the question is smaller.
What changes the answer
- Who produces the revenue. The more of the firm's gross receipts come from your own legal work, the more of what you take out should be wages; receipts produced by non-shareholder employees and by capital can support distributions (IRS S corporation compensation page).
- Management time. A managing lawyer who bills little but supervises the people who do is still performing services the IRS expects to see paid as wages (IRS S corporation compensation page).
- Health insurance premiums. Premiums the firm pays for a more-than-2% shareholder are reported as wages in box 1 of the owner's Form W-2 but not in the Social Security and Medicare boxes when paid under a plan for employees; see how S corporation owners handle health insurance.
- The qualified business income deduction. Section 199A(c)(4) excludes reasonable compensation paid to the taxpayer from qualified business income, so salary and the deduction interact; see whether a lawyer can take the 20% qualified business income deduction.
- Firm size. If total receipts are $500,000 or more, the Instructions for Form 1120-S (2025) require Form 1125-E, which reports compensation of officers in detail.
- How income reaches you. Wages carry income tax withholding under Publication 15; distributions do not. A low salary usually means larger quarterly estimated tax payments.
For example: a solo firm with one paralegal
For example, imagine a lawyer whose S corporation earns $200,000 before her own pay. She does nearly all of the legal work, with one paralegal. Using salary data for lawyers with her experience in her area and her full-time schedule, she sets her salary at $110,000 and records the method in a board resolution. Payroll tax on that salary is 15.3%, or $16,830, half withheld from her pay and half paid by the firm. After her salary and the firm's $8,415 share, about $81,585 remains for distribution, which carries no Social Security or Medicare tax. Had she paid herself $30,000 while producing nearly all the revenue, the IRS's own test, which follows the source of the receipts, would point toward reclassifying part of the distributions as wages. This is a hypothetical, not a real case.
Common mistakes with S corporation salaries
- No salary at all. The firm's planning page calls this out: an S corporation owner with no W-2 needs attention.
- A number with no method. A salary picked as a round share of profit, with nothing showing how it was set, is hard to defend; a reasonable salary needs to be documented.
- Distributions all year, payroll in December. The IRS expects reasonable compensation before non-wage distributions, and wages paid late in the year still have to be withheld and deposited on time.
- Ignoring non-billable work. Management and supervision count as services under the IRS's guidance.
- Leaving health insurance off the W-2. Premiums for a more-than-2% shareholder belong in box 1 wages.
- Never updating the number. A salary set in the firm's first year may no longer fit five years later.
What to do this week
- Pull the last three years of Forms 1120-S, K-1s and your own W-2s, and compare wages with distributions.
- Write a one-page description of your duties and weekly hours.
- Estimate what share of the firm's revenue comes from your own work and what comes from staff.
- Gather pay data for lawyers in similar roles in your market, with the date and source.
- Record the salary and its basis in a memo or board resolution.
- Confirm with your payroll provider that withholding and deposits match the new salary.
Frequently asked questions
Is there a percentage rule, such as 60/40?
Not in the IRS's guidance. Its S corporation page lists factors to weigh rather than a ratio, and it treats a formula as one factor, not a safe harbor.
Can I pay myself less in a slow year?
The salary should follow the work, so a year with less work or less revenue can support a different number if you document why. The IRS notes that reasonable compensation never exceeds what the shareholder actually received.
Does a higher salary always cost more tax?
It adds payroll tax, but it also changes other figures, such as the qualified business income deduction, because section 199A excludes reasonable compensation from qualified business income. That is why the salary decision should be reviewed alongside the rest of the return.
What if the IRS questions my salary in an audit?
The examiner will ask how the number was set, which is where the documentation matters. If you disagree with a proposed adjustment, the process and your options are covered under IRS audits and examinations.
Do I report the salary differently because I own the firm?
No. You receive a Form W-2 like any employee, and the firm files Form 941 each quarter and deposits the taxes on its schedule.
Can the firm pay me a bonus instead of a higher salary?
A bonus is wages, so it counts toward reasonable compensation and carries withholding and payroll tax like salary. Publication 15-B (2026) notes that the flat withholding rate on supplemental wages remains 22%, or 37% on supplemental wages above $1 million in a year. Because the IRS lists the timing and manner of bonuses as a factor, a written bonus policy helps.
What if two lawyers own the S corporation?
Each shareholder who works in the firm needs reasonable compensation for that person's own services, so the two salaries can differ when the work differs. Distributions are another matter: the Form 2553 instructions explain that an S corporation can have only one class of stock, generally meaning all shares carry identical rights to distribution and liquidation proceeds.
Who reviews the salary each year?
Many owners review it with their tax adviser when the year's results are known. A detailed owner benefits and reasonable compensation analysis is the first-quarter topic of the firm's Quarterly Tax Health Checkup.
A salary you can defend
Kathryn Meyer spent more than two decades in the IRS Office of Chief Counsel and now helps law firm owners set and document compensation that holds up to review. For a structured yearly look, see the Annual Tax Health Checkup. Contact the firm or call (571) 560-8674.
Sources
- IRS, S corporation compensation and medical insurance issues
- IRS, Instructions for Form 1120-S (2025)
- IRS Publication 15 (2026), Employer's Tax Guide
- Social Security Administration, Contribution and benefit base
- IRS Publication 15-B (2026), Employer's Tax Guide to Fringe Benefits
- IRS, Instructions for Form 2553
- 26 U.S.C. 199A, Qualified business income