How S Corp Owners Can Legally Reduce Their Taxes with a Reasonable Salary Strategy

One of the biggest tax opportunities for S Corp owners is also one of the most misunderstood: how you pay yourself.

In fact, this comes up in multiple client conversations. Many S Corp owners are unintentionally overpaying in taxes because their compensation structure hasn’t been reviewed strategically.

Let’s break down how it works, what “reasonable compensation” really means, and how S Corp owners can reduce payroll taxes without raising red flags.

Where Many S Corp Owners Go Wrong 

As an S Corp owner, you’re required to pay yourself a reasonable salary for the work you perform in the business. That salary runs through payroll and is subject to Social Security and Medicare taxes.

What many owners don’t realize is that profits above that reasonable salary can be taken as distributions, which are not subject to payroll taxes.

The problem I see most often?

Owners pay themselves too much as salary, out of caution or because no one ever revisited the strategy as their role changed.

That usually means they’re paying far more payroll tax than necessary.

A Real Example from a Client Conversation 

In a recent strategy session, we reviewed the financials and compensation of an S Corp owner.

At first glance, it looked like the business had a revenue problem - profit felt tight and cash constrained.

But after digging into the numbers, it became clear that wasn’t the issue.

Expenses were quietly eroding margins and the owner was paying himself a salary that reflected a full-time CEO role.

In reality, his role had evolved. He was spending far less time on day-to-day operations and much more time in a chairman or strategic position.

When we talked about his responsibilities, we found that reducing his salary by $100,000 could save approximately $15,000 per year in payroll taxes with potential savings up to $30,000 if adjusted further.

The remaining income could be taken as distributions, rather than payroll.

And it wasn’t about avoiding taxes. It was about paying the right amount, the right way.

What “Reasonable Compensation” Actually Means

Reasonable compensation isn’t a guess, and it’s not a number you pick because it feels safe.

The IRS looks at things like:

• What you actually do in the business
• How much time you spend on different responsibilities
• Market pay for similar roles in your industry and region
• Whether you’re acting as an operator, executive, or owner-only
• The size and profitability of the business

In the example above, the salary didn’t match the role anymore — and that mismatch created unnecessary payroll taxes.

What a Smart Reasonable Salary Strategy Looks Like 

A thoughtful approach typically includes:

• Reviewing the business’s overall financial health
• Walking through what the owner actually does day to day
• Comparing that role to market compensation data
• Setting a defensible reasonable salary
• Taking additional profit as distributions where appropriate
• Documenting the analysis
• Reassessing annually as the business evolves

At its core, the distinction is simple:

• Salary → subject to payroll taxes
• Distributions → not subject to payroll taxes

Once a reasonable salary is set and properly documented, shifting excess profit to distributions can create meaningful, recurring tax savings.

What Not To Do When Determining a Reasonable Salary 

On the other end of the spectrum is having no methodology at all and paying yourself as little as possible. In fact, when approving an S Election, the IRS now includes the following language on the notice:

“You must determine a reasonable salary when a shareholder-employee of an S corporation provides services to the corporation. Payments to a shareholder-employee for services provided to an S corporation are wages and are subject to employment taxes. We may re-characterize distributions paid to a shareholder as salary if the distribution was paid in lieu of reasonable compensation.” (Revenue Ruling 74-44)

What does “reclassification” mean? Distributions, back payroll taxes, penalties, and interest will rack up if you’re paying yourself too little or nothing and get caught.

Turning Strategy into Results 

In our example above, reducing the owner’s compensation didn’t just reduce taxes. It clarified profitability, improved cash flow visibility, and made tax planning more intentional.

That’s why a reasonable salary strategy works best when it’s paired with clean books and regular financial review — not just a year-end tax return.

When compensation reflects how the business actually operates, tax savings follow naturally — legally and sustainably.