Somebody will tell you the rule is 60/40. Sixty percent salary, forty percent distributions, and the IRS leaves you alone.
That number appears nowhere in the Internal Revenue Code, nowhere in the regulations, and in no published ruling. It is a rumour with unusually good distribution. Preparers repeat it because the alternative is a facts and circumstances test, and nobody wants to explain a facts and circumstances test to a client who wanted a number.
Here is the actual standard, what the courts weigh, and what the number touches once you set it.
The rule, such as it is
An S corporation shareholder who performs services for the corporation is an employee, and has to be paid reasonable compensation for those services before non-wage distributions are made.
That is it. There is no percentage, no bracket, no safe harbour. The IRS position rests on a line of authority going back to Revenue Ruling 74-44, which recharacterized distributions as wages where a shareholder took distributions in place of salary.
The reason the rule exists is arithmetic. Wages carry Social Security and Medicare tax. Distributions do not. Both land on the shareholder's 1040 and both are taxed as income, so the incentive is not about income tax at all. Shift a dollar from wages to distributions and the income tax barely moves while the payroll tax disappears.
Which is why the examination, when it comes, is a payroll tax examination.
What the courts actually weigh
The factors are consistent across cases and they are the right checklist for your file:
Training, experience and qualifications of the shareholder. Duties actually performed, and hours actually devoted. What comparable businesses pay for comparable work. What the corporation pays its non-shareholder employees. The timing and manner of paying bonuses. Dividend and distribution history. And whether an unrelated person would have accepted the same arrangement.
Read that list against a real client and it usually answers itself. A sole shareholder working fifty hours a week running a profitable contracting business is not credibly a 12,000 a year employee, whatever the distributions say.
The case preparers cite most is Watson, where an accountant with substantial credentials and a full workload paid himself 24,000 while taking roughly 175,000 in distributions from a profitable firm. The court accepted the government's expert and recharacterized wages up to around 91,000. What is instructive is not the number. It is that the court reached it by asking what someone with those qualifications doing that work would be paid by an unrelated employer.
That is the question. Not what percentage keeps you safe.
The return that asks for the audit
The pattern is not subtle and it is fully visible from the filing:
Officer compensation of zero on Form 1120S line 7. Distributions of 120,000 on Schedule K. A corporation whose only worker is its owner. No W-2 issued, and therefore no 941s reporting any wages.
Every element of the case is printed on the face of the return. Nothing has to be discovered. A shareholder performed services, the corporation had profit, and no compensation was paid.
Zero is the version that gets caught. The more common real world version is a salary that is plausible in isolation but never moves. The same 40,000 appears on the W-2 for six straight years while distributions climb from 30,000 to 180,000. Nobody chose 40,000 as reasonable compensation. It was chosen once and then carried forward, which is a different thing, and it is much harder to defend precisely because there is no analysis behind it.
Documenting it takes an afternoon, once
The defence is contemporaneous documentation, and it does not have to be elaborate.
Write down the shareholder's role and hours. Pull two or three comparable salary figures from a compensation survey, a job board, or industry data, and keep the source. Note anything that legitimately reduces the figure: a genuinely part time owner, a business where most profit comes from capital or from other people's labour rather than the shareholder's own work. Then set the number and put it in the file.
That last category is real and gets ignored. A shareholder who owns a business with fifteen employees and spends ten hours a week on it is not entitled to a low salary because they want one, but they are entitled to one because a substantial part of the profit is generated by other people. Capital and other workers earn a return. Distinguishing that return from the owner's own labour is the entire exercise.
Revisit the figure when the business changes materially. A salary set when the company had three employees and 400,000 of revenue is not evidence about a company with twelve employees and 2 million.
What the number touches
Reasonable compensation is not a single entry. Setting it moves several things at once, which is why fixing it late is expensive.
It sets Form 1120S line 7, officer compensation, which reduces ordinary business income and therefore reduces what flows to every shareholder on Schedule K-1.
It sets the W-2 and the quarterly 941s. These are the returns that actually have to change if the figure changes, and they are filed throughout the year rather than at the end.
It interacts with the qualified business income deduction. W-2 wages paid by the business feed the wage limitation, so the salary figure can affect the shareholder's own deduction in both directions. Higher wages reduce the qualified business income itself while raising the wage limitation. There is no simple rule here and it does not always point the same way.
It also governs shareholder health insurance. Premiums paid for a more than 2 percent shareholder have to be included in that shareholder's W-2 wages to be deductible by them. No wages means no W-2, which means the mechanism has nowhere to attach.
The cost of getting it wrong is not just the additional payroll tax. It is a W-2c, amended 941s for the affected quarters, penalties and interest, and a conversation with a client about a year they considered closed.
Where Ledger IQ fits
Ledger IQ does not tell you what reasonable compensation is. That is judgment, and it depends on facts the trial balance does not contain.
What it does is make the two numbers in the argument visible and correctly placed, which is where the practical errors live.
Officer compensation maps to its own named return line rather than dissolving into a general payroll account, so line 7 carries what you intended and the shareholder's wages are separated from everyone else's. Distributions map to the distribution line rather than sitting in an expense account as an owner draw, which is the single most common reason a set of books understates both distributions and profit at the same time.
Because the Working Trial Balance shows every account mapped to a line, you can see officer compensation and distributions side by side on the same workpaper before the return is filed. That comparison is the one an examiner makes first, and it is better to make it yourself in January than to have it made for you later.
Ledger IQ supports Forms 1065, 1120S and 1120, with exports for Drake, Lacerte and UltraTax CS. It is free during early access, so you can try it at portal.ledgeriq.ai on a live client without a credit card.