Reasonable Salary
Definition
A Reasonable Salary is an IRS requirement for business owners who have elected S-Corporation tax status. Because S-Corps allow owners to take tax-free "distributions" to avoid self-employment tax, the IRS requires that the owner first pay themselves a fair, market-rate W-2 salary for the actual labor they provide to the business.
Why it matters
If you own an S-Corp and take all of your profits as distributions (paying zero self-employment tax), the IRS will audit you. They will reclassify your distributions as wages and hit you with severe back-taxes and penalties. Determining what is "reasonable" requires looking at what you would have to pay a non-owner employee to do your exact job in your geographic area.
Example
Greg runs an S-Corp marketing agency that nets $150,000. He researches what a Marketing Director makes in his city and finds the average is $70,000. Greg puts himself on formal W-2 payroll for $70,000 (his reasonable salary), paying standard payroll taxes on that amount. He takes the remaining $80,000 as an owner distribution, which is free from self-employment taxes.