A CPA named David Watson paid himself a $24,000 salary from his one-person accounting firm while pulling more than $200,000 a year in distributions. The IRS took him to court over it — and won. A federal appeals court ultimately decided his "reasonable compensation" should have been $91,044, not $24,000, and hit him with more than $23,000 in back payroll taxes, penalties, and interest.
Watson isn't a cautionary tale about a shady operator gaming the system. He's a cautionary tale about following bad advice. He'd heard the same rule of thumb that circulates in small-business forums, Facebook groups, and more than a few tax-prep offices to this day: pay yourself a modest salary, take the rest as distributions, and skip the payroll tax on the difference. It sounds like smart tax planning. It's actually the single most common trigger for an S-corp audit.
If you own an S-corp — or you're thinking about electing S-corp status for your LLC — how you split your own paycheck between salary and owner's draw isn't a minor bookkeeping detail. It's a compliance decision with real financial consequences if you get it wrong, and real tax savings if you get it right.
Why This Question Only Exists for S-Corps
Sole proprietors, single-member LLCs, and partners in a partnership don't have this choice to make. Every dollar of profit that flows to them is self-employment income, full stop — subject to the full 15.3% self-employment tax (12.4% Social Security up to the annual wage base, plus 2.9% Medicare) regardless of whether they call it a "draw" or leave it in the business.
S-corps work differently. An S-corp is a pass-through entity for income tax purposes, but for payroll tax purposes, the IRS treats an owner who actively works in the business as an employee. That creates two separate buckets of money:
- Salary (W-2 wages): Runs through payroll, subject to the full 15.3% FICA tax (split between the corporation and the employee), income tax withholding, unemployment tax, and workers' comp in most states.
- Distributions: Your share of the company's remaining profit, paid out based on ownership percentage. Distributions are not subject to FICA or self-employment tax — only ordinary income tax.
That gap is exactly why S-corp elections exist for profitable small businesses in the first place, and exactly why the IRS scrutinizes how owners split the two. Every dollar you move from salary to distributions saves you 15.3% in payroll tax (or 7.65% from the employer side plus 7.65% from the employee side, since you're both). Move enough, and the temptation to pay yourself the bare minimum in salary becomes obvious.
The 60/40 Rule Is Not a Real Rule
Search "S-corp salary" online and you'll run into the "60/40 rule" almost immediately: pay 60% of distributable profit as salary, take 40% as distributions, and you're safe.
The IRS has never published this ratio. It doesn't appear in any regulation, revenue ruling, or court opinion. It's an industry shorthand — a rough heuristic some accountants use as a starting point for a conversation, not a legal safe harbor. Treating it as one is exactly the mistake that catches owners off guard: the IRS doesn't check whether you hit a percentage. It checks whether your salary reflects fair market value for the work you actually did.
A single-owner consulting firm netting $500,000 where the owner does 100% of the client-facing work needs a very different salary than a business with the same profit where the owner spends most of their time managing five employees who do the delivery work. A fixed ratio can't capture that distinction — and an IRS examiner won't accept it as a defense.
What the IRS Actually Looks At
The IRS's own training materials for examiners (Fact Sheet FS-2008-25) and a string of Tax Court decisions have converged on a facts-and-circumstances test built around factors like:
- Training and experience. A CPA with 20 years of experience and a specialty certification commands a different market wage than someone doing the same job with two years of experience.
- Duties and responsibilities. Are you the person actually delivering the service that generates revenue, or are you primarily managing others who deliver it?
- Time devoted to the business. Full-time versus part-time matters — an owner working 10 hours a week has a lower reasonable-salary floor than one working 50.
- What comparable employees are paid. If you have a non-owner employee doing similar work for $80,000 a year and you're paying yourself $30,000 for the same role, that's a flashing red flag.
- What comparable businesses pay for the role. Salary surveys and industry wage data for your role, seniority, and geography are the backbone of most defensible calculations.
- Dividend/distribution history. A pattern of minimal salary alongside large, regular distributions — especially before a public offering, a sale, or a loan application, when suddenly your "true" earnings matter — undermines your position.
- Whether payments correlate with services performed, not just with how much cash the company has on hand.
The clearest statement of the underlying principle: to the extent your S-corp's revenue is generated by your personal services, the IRS expects that portion to be classified as wages. Only profit attributable to capital, employees, or the business itself belongs in the distribution bucket.
The Case That Set the Benchmark
Watson's case matters because it shows exactly how the IRS builds its argument. Watson had transferred his interest in a successful accounting practice into a wholly-owned S-corp. In 2002 and 2003, salary made up only about 11% of his total compensation from the company — $24,000 a year — while distributions made up the other 89%, over $175,000–$200,000 annually.
The IRS didn't argue that Watson's total pay was too high. It argued the label was wrong. Using an AICPA salary survey for accounting professionals, the IRS's expert built a baseline salary for a director-level accountant (~$70,000) and adjusted upward roughly 33% for his ownership responsibilities, landing on approximately $93,000. Courts ultimately settled on reasonable compensation just above $91,000 — meaning roughly $69,000 of what Watson had called "distributions" each year actually should have been salary, subject to payroll tax he hadn't paid.
Other Tax Court cases point to a rough practical floor: officer compensation for an actively working owner should land in the neighborhood of at least 70% of the comparable market rate for the services performed — a benchmark, not a rule, but a useful gut check when a proposed salary looks suspiciously low relative to what the role would cost to hire out.
How to Actually Set Your Number
Skip the fixed ratio. Work through this instead:
1. Price out your job, not your ownership. Ask: if I had to hire someone off the street to do exactly what I do — same hours, same duties, same seniority — what would that role pay in my market? Use Bureau of Labor Statistics wage data, industry salary surveys, or job postings for comparable roles as a starting point.
2. Separate "worker" pay from "owner" return. Your reasonable salary compensates you for labor. Everything left over after paying yourself, your other employees, and your business expenses is a return on the capital and risk you've put into the business — that's what distributions are for. If your S-corp has no employees besides you and does no work without you personally showing up, expect a much higher share of profit to look like salary in the IRS's eyes.
3. Document it. A one-page memo listing your role, your hours, comparable market wages you referenced, and your reasoning is worth more than any percentage rule if you're ever audited. Dedicated services like RCReports build this analysis formally (blending IRS criteria, court precedent, and wage databases into a defensible report) for a few hundred dollars a year — cheap insurance against a five-figure reclassification.
4. Revisit it annually. Reasonable compensation isn't a one-time decision. As your revenue, duties, and market wages shift, your salary should shift with them. A number that was defensible three years ago may not be defensible today.
5. When profit is thin, salary can legitimately be low — or zero. The reasonable-compensation rule is triggered by services performed, not by having an S-corp election. If the business isn't generating enough profit to support a market wage, a low or deferred salary can be entirely appropriate; the problem only arises when substantial profit is being taken as untaxed distributions while a genuine, revenue-generating role goes uncompensated.
Why This Starts With Clean Books
None of this works if you can't see the split clearly. Reasonable compensation isn't just a payroll-run decision — it's a bookkeeping discipline. You need to be able to show, at any point, exactly how much you've taken as W-2 salary (run through payroll, with taxes withheld) versus how much you've taken as owner distributions, and tie both back to your business's actual profit for the year. Owners who commingle the two, or who can't produce a clean answer when their accountant asks "how much have you distributed so far this year," are the ones who end up guessing at a percentage instead of defending an actual number.
This is where transparent, structured financial records earn their keep. Beancount.io gives you plain-text, version-controlled accounting where every distribution and every payroll run is a discrete, auditable entry — not a bank balance you're reverse-engineering at tax time. Track salary and distributions in separate accounts from day one, and the "how did we split it" conversation with your accountant (or an IRS examiner) becomes a five-minute lookup instead of a forensic reconstruction. Read more in the docs on setting up an accounting structure that separates owner compensation cleanly, or see how Fava turns those entries into a dashboard you can check before every payroll run.
The Bottom Line
There's no IRS-blessed formula for splitting owner's draw and salary — no 60/40, no magic percentage that keeps you safe. What keeps you safe is a defensible answer to one question: what would it cost to hire someone else to do what I do? Pay yourself that, take the rest as distributions, document your reasoning, and revisit it every year. It's less exciting than a rule of thumb, but it's the only approach that's actually held up in court.